VI: Understanding Advisor Compensation Principal-Agent Problems

Steven E. Landsburg, in The Armchair Economist: Economics and Everyday Life, wrote: “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary.” In this article, we explore principal agent issues and potential conflicts of interests between investors and their advisors.

Principal-Agent Problems: What They Are and Why They Matter 

The principal-agent problem occurs when a principal (investor) hires an agent (investment advisor) to act on its behalf even when the agent’s interests may diverge from those of the principal.

In the investment industry, typically the investor’s primary interest is realizing long-term growth in assets, while the investment advisor prefers a healthy and steady stream of fee income. This may not appear to be a problem, as investment advisors are hired to deliver long-term performance and should strive to satisfy their clients.  

Moreover, investors would not purposefully overpay or retain ineffective investment advisors. The problem, though, occurs when the investment advisor places its business interests ahead of the client’s investment interests. 

There are clear conflicts of interest pertaining to compensation, but also subtle principal-agent problems that neither investors nor investment advisors always truly appreciate. By better understanding the potential conflicts, investors can be more aware of their investment advisors’ motives and able to question whether their actions and recommendations are truly in the investors’ best interests. 

The vast majority of investment advisors are ethical and seek to do what they believe is in their clients’ best interest. Few seek to take advantage of their clients, but rather, work hard to help their clients achieve their investment objectives. Nevertheless, the principal-agent problem still exists.  

Although investors may not consciously contemplate these issues, most investors understand investment advisors are in business to earn money and therefore do not want to lose clients. Consequently, investors should be aware that investment advisors’ business interests sometimes could conflict with investors’ long-term investment interests. 

This article reviews common compensation-related conflicts of interest, as well as less obvious client retention principal-agent problems. In all instances, the investor is the principal, and the agent assumes fiduciary responsibility. Fiduciaries are required to act in the client’s best interest, disclose and reduce any conflicts of interest, and manage assets prudently. 

Fiduciary agents can be categorized into two main groups:

• Investment managers, including separate account, commingled fund, and mutual fund managers. This group selects securities for a specific mandate (e.g., large cap value, international equity, core bonds) and typically manages only a portion of the overall portfolio.
• Consultants, outsourced chief investment officers, and other advisors. This group is responsible for the overall portfolio and either has discretion over portfolio construction and manager selection/termination, or makes recommendations to the investor. In terms of fiduciary responsibility, there is little difference between those with discretion and those who make recommendations. In both cases, the advisor has a fiduciary responsibility to act in the client’s best interest.

Although the principal-agent problem for staff members is not explored here, boards should be cognizant that staff members prefer to keep their jobs and can fall victim to some of the same influences as outside agents. 

Recognizing Compensation-Related Conflicts of Interest 

Despite a heightened sensitivity around fiduciary responsibility, many egregious conflicts of interest still exist. These conflicts pertain to compensation structures, where investment advisors are incentivized to act in ways that place their compensation ahead of their clients’ best interests. For those focused on good governance, these practices are troubling, and the fact that some investors do not recognize these conflicts is disappointing. Below are notable compensation-related conflicts of interest that investors should avoid. 

Fee-Sharing  

Although not as common as in decades past, some investment advisors receive fees from the managers/funds they recommend or select for their clients. This fee-sharing compensation can be in the form of commissions, mutual fund loads, or 12b-1 fees. In all cases the advisor has an incentive to recommend or select certain funds over others because the compensation is greater. The advisor also may have an incentive to churn the portfolio (i.e., sell current holdings and purchase new holdings) to collect additional compensation. 

Affiliated Brokers 

Some investment advisors and managers are affiliated with brokerage firms and trade on their platforms. They may argue that this affiliation helps them to achieve better trade execution, but the incentive to trade to generate more commission dollars is a definite conflict. Even if the advisor does not trade with the affiliate, they may favor investment managers who trade a great deal with the brokerage arm, presenting another conflict. 

Manager-Sponsored Conferences 

A few consulting firms host client conferences and solicit investment managers as sponsors. These conferences are educational and the clients benefit from the content and networking opportunities, but the sponsoring investment managers pay the consultant for the benefit to attend. Why do the investment managers sponsor these conferences? To spend a day or two trying to stand out among dozens of their competitors in front of potential clients or to gain favor with the consulting firm that may recommend them? When deciding who to recommend in a manager search, do the consultants favor the sponsoring managers over those who did not sponsor? Perhaps some consultants can remain impartial, but many fall prey to the human tendency to favor those who help them. 

Using Proprietary Funds/Affiliated Managers 

Some investment advisors will recommend/ invest in proprietary funds or affiliated managers. In doing so, the advisor’s objectivity may be compromised.  

Consider an investment advisor working at a brokerage firm or bank (or even an independent registered investment advisor) that invests with both outside fund families and proprietary funds/affiliated managers. 

A few questions immediately come to mind: Can the advisor truly be objective in evaluating the proprietary funds/affiliated managers? Are there additional incentives for the advisor to invest with the proprietary funds/affiliated managers? What other fee arrangements are involved? Even if there are fee rebates and concessions that do not change the overall compensation to the advisor, thereby providing a justification for the advisor to employ this approach, the advisor’s firm still benefits from additional assets in these funds (or with these affiliated managers). Additional assets help to spread operational costs, thereby lowering the expense ratios on the proprietary funds. Lower expense ratios and larger asset bases can help in the marketing of these funds. 

Similarly, consider a consultant who recommends their clients invest with the firm’s proprietary private capital or hedge fund of funds. Often these fund of funds are designed to help smaller clients access the same private capital or hedge fund managers as their larger clients. The benefits to the investor are lower fees than other fund of funds and a consultant with keen knowledge of the underlying managers. The obvious conflict occurs when the consultant generates more revenue by recommending the proprietary fund of funds in place of external funds.  

Nevertheless, conflicts can occur even if management fees are rebated, as the consulting firm still benefits from the larger asset base and the spreading of operational costs across additional investors. When consultants recommend proprietary funds, can they still be objective in evaluating these funds? 

Even if the fund of funds is an appropriate vehicle for investment, can the consultant be influenced in other areas? For example, will they be more likely to recommend higher allocations to private capital and hedge funds? Will their capital market assumptions (used in asset allocation studies) accurately reflect the expected returns, risks, and correlations inherent in these strategies? Or will they adjust the assumptions to favor higher allocations to these strategies? And will the investors who use the consultant’s fund of funds recognize that they are more reliant on the consultant because they have a large part of their assets tied up in these funds? 

Different Fee Schedules 

Some investment advisors, such as those affiliated with banks and brokerage firms, may invest only with proprietary funds. Investing across multiple proprietary funds eliminates the conflicts between outside and proprietary managers, but introduces new conflicts if the funds have different expense ratios. For example, suppose the advisor invests in two funds, an equity fund and a fixed income fund. The equity fund’s expense ratio is 0.75% and the fixed income fund’s expense ratio is 0.40%. Because the firm collects higher fees with the equity fund than the fixed income fund, the advisor faces a conflict of interest when allocating between the two funds. 

Another conflict arises when investment advisors and consultants charge higher fees for additional services. Because these additional services require increased resources, the higher fee may appear justified and not a conflict of interest, especially if the investor must agree to the new fee schedule. Nevertheless, the advisor still has an incentive to “up-sell” the client. 

For example, a consultant may charge higher fees to advise on “alternative investments” such as private capital and hedge funds.  

If the consultant’s client does not currently invest in “alternative investments,” the consultant has an incentive to increase its compensation by recommending the investor move to a higher level of service. The consultant may believe this is in the client’s best interest, but the additional compensation introduces potential conflicts.  

Similar to the example of the consultant who offers a fund of funds, investors must be aware that the consultant has an incentive to “sell” the benefits of “alternative investments,” downplay the disadvantages, and adjust the firm’s capital market assumptions to demonstrate the benefits of including “alternative investments” in the portfolio. 

A better approach would be to have one fee schedule for all clients, thus eliminating this conflict. 

Summary 

Incentives drive behavior. Investment advisors may seek to justify why certain conflicts are not an issue and in the best interests of their clients. They may even believe this. Some will argue that disclosing a conflict of interest absolves them of the conflict.  

Nevertheless, human beings respond to incentives, and no matter how ethical people think they are, when additional compensation is available, most will find remaining completely impartial difficult, even if this is at a subconscious level. Thus, investors would be wise to avoid investment advisors that share fees, trade through affiliate firms, ask managers to sponsor conferences, invest with proprietary funds, or have incentives to “up-sell” their clients.