Your investment manager should be incentivised in a way that serves your best interest.
Do you invest in the stock market?
If not, you should.
Why?
Because the stock market is the greatest wealth creator of our times. Perhaps, also the most easily accessible asset class: anyone with a PAN card and a bank account can open a trading account and buy shares for as low as ₹100.
You can invest directly in the stock market by opening a trading account with a brokerage firm. If so, you pay a brokerage commission (usually 0.2 – 0.5 percent of traded value) to your equity broker whenever you buy or sell shares. If you are investing in markets (or intend to invest) this way, you must do your research to identify which stocks to buy or sell. Additionally, your brokerage house might guide you with regular investment idea recommendations through equity research reports published by their research departments.
Otherwise, you can invest indirectly in the stock market through mutual funds: these are investment vehicles created with money pooled from investors and managed by a fund manager with the support of a team of equity analysts. They charge you an annual maintenance fee for their services, typically 0.5 – 2.5 percent of the fund size.
However, if you are investing directly – through a brokerage account – the responsibility of identifying stock ideas, building an equity portfolio, and finally, achieving superior investment return falls on you, whereas if you are investing indirectly – through mutual funds – the respective responsibility is on the fund manager.
Which is best for you to invest in the stock market?
It depends… on your risk appetite… your understanding of the markets… and the level of your analytical skill and knowledge…
If you believe that you have the necessary skill and knowledge to analyse the business and financials of companies and identify opportunities – you may choose the direct route. If not, then the quest becomes more complex.
If an investor decides to seek outside help for investment decision-making – the widely available routes are – to rely on the recommendations of their stock brokerage firm – or to invest in well-managed mutual funds.
However, before you select an optimal route to markets, reviewing the available routes’ incentive structure is advisable. The route where the incentives and interests of both the investor and the intermediary are closely aligned – is most beneficial to the investor.
Real wealth is created over the long term, and that may require you to stay invested in a quality stock for five to ten years – sometimes much longer. However, your broker’s principal income is the commission they receive when you buy or sell stocks through them. Your broker is disincentivised if you decide to buy and hold a stock for five years – they earn commission only when you buy or sell shares.
Your broker’s interest is well-served if you frequently purchase and sell shares – earning them hefty commissions in the process – but this comes at a significant cost to you – in the form of diminished returns. The point I wish to make here is that your interest and your broker’s interest are extremely misaligned. Therefore, you should maintain a high degree of scepticism when relying on their investment recommendations.
Mutual funds levy an annual maintenance charge – expressed in percentage terms, called expense ratio (%) – on its investors for managing their money. In India, the expense ratio ranges from 1.5 to 2.0 percent for a vast majority of mutual funds. This is charged on the total fund size: that is, suppose you have invested ₹10,000 in a fund with an expense ratio of 1.5 percent, then you will be charged an annual maintenance charge of ₹150. If the invested value rises to ₹11,500 one year later, you will be charged 1.5 percent of ₹11,500, i.e., ₹172.50, for the year.
As an investor, your goal is to achieve superior investment return, but mutual funds are not incentivised based on how much return it makes for you (the investor). Rather, their incentive is related to the size of the fund – the total amount of money they manage. So here too, the interests of the mutual parties – the investor and the mutual fund – are misaligned.
A fund manager might be coerced to prioritize investor return as a series of poor returns by the fund will lead to investor withdrawals reducing the fund size, and a reduced fund size means lower annual maintenance charges. So, we may presume that making a good return for the fund is in the interest of both the fund and the investor. But this is an indirect and fragile linkage. There is still no direct alignment of interests between the investor and the mutual fund.
Then, when does the interest of an investor and his investment intermediary align – directly and closely? It is aligned when the intermediary is incentivised for the return (profit) he makes for the investor. The interests are most closely aligned when the intermediary is compensated with a share of the profit he makes for the investor. This incentive is called the performance fee.
Suppose that your intermediary (your investment manager) – with a performance fee of 20 percent – makes a 15 percent return on your ₹10,000 investment. He has made a profit of ₹1,500 for you – and you pay a performance fee of ₹300 (20 percent of ₹1,500) to him. As a result, after fees, your investment will be now worth ₹12,000 – an after-fee return of 12 percent. If the intermediary had made a lower return, then he would be paid a lower performance fee; likewise, if he had made a higher return, he would receive a higher performance fee.
Therefore, an arrangement where the performance fees garner – a disproportionate share of your investment manager’s total incentive – is the one in which your and your investment manager’s interests are most closely aligned.
However, this contemplation into the incentive structure where investors’ interests and manager’s interests are closely aligned doesn’t end with performance fees. There is another important aspect that needs careful consideration: the role of luck in investment performance.
In investing, particularly in the stock market, the share of luck and skill in a manager’s performance is a long-standing contentious issue. A fund return of 5 percent made in a year when the market index declined by 10 percent is superior to a 15 percent fund return made in a year when the market index gained 18 percent. In the first case, the manager outperformed the market by 15 percent, while in the second case, he underperformed the market by 3 percent.
In investing, both skill and luck can have a significant role in a fund’s total return. You don’t want to compensate your investment manager for being lucky; you want to compensate him for his skill. Therefore, the best measure of a manager’s performance is the relative performance of his fund to a benchmark index – like Nifty, Sensex, Nifty 500, etc.
An investment manager’s incentive for managing your money should be a ‘relative performance fee’ – an incentive structure in which an enormous part of a manager’s fee is determined by how much he outperforms the benchmark index.
AMN CAPITAL 