As the financial industry has been evolving from brokers selling financial products to Registered Investment Advisors (RIA) selling advice, the nature of fees has changed. Stock brokers made their money on sales commissions, which misaligned their financial interests with those of their clients.
The RIA fee model, in most cases, is based on a percentage of assets under management (AUM), generally in the vicinity of 1%. This appears to align RIA's interests with those of their clients because if the client account goes up in value, so do their fees, and vice-versa.
The problem with this fee arrangement is that the interests of RIAs and their clients are not exactly the same. Financial firms have a business to run. Wealthy clients generally have longer time horizons. This difference actually misaligns interests. Advisory firms would generally prefer to have the portfolios that they manage in less volatile assets, providing greater certainty of returns in the short-term (one-year) than their clients.
Following the 2008/09 financial crisis, some advisory firms switched to a fixed-fee revenue model to obtain greater security of income. But fixed-fee models have been shown to net advisors lower income than the floating AUM fee model.
"Salient" payment mechanisms require the client to write a check in many cases. That in-your-face quality makes this fee model inherently more difficult for advisors to market, and makes it harder for advisors to retain clients, compared to the AUM model, where monthly fees can be directly deducted by the advisor from client accounts.
Advisors have found it difficult to raise fees in "up markets" for performing the same services. In "down markets," they face competition from the AUM fee model, which charges lower fees at lower AUM levels. Because of this latter issue, fixed fees are subject to being renegotiated lower when asset prices drop anyway, not resolving the problem of variable fees.
If a firm hedges its fee income, it gets the best of both worlds: the higher-valued AUM fee revenue model, combined with greater certainty of income when asset prices fall. To be clear, the advisory firm just hedges its income with its money, not its clients' portfolios with their money.
For example, if an advisor has $1 billion AUM and charges a fee of 1% of AUM, it would earn $10 million for the year. It would hedge the risk to the $10 million fee stream, not the $1 billion AUM.
Although RIAs with AUM revenue models rarely think that they are in the commodity business, their income fluctuates with asset prices just as an oil producer's revenues fluctuate with oil prices. If an advisor is managing conventional stock/bond portfolios for clients, the value of the AUM will drop if equity markets drop, all else being equal. During a significant drop, advisors' fees drop not only because of a drop in stock market prices, but also because some clients withdraw funds to reallocate to money market accounts, compounding the problem.
Unexpected declines in advisors' fees can make it difficult for financial firms to meet overhead. In 2014, RIAs dramatically increased their overhead by raising the compensation of their employees.
There are many different ways to hedge AUM fee income, and I recommend a six-step process (see below). I have used that process for decades to assist more than one hundred energy firms and large end-users of energy products to define their hedging program.
One mistake made by an RIA client of mine was that they had bought a hedge product that was designed to hedge a client portfolio. But AUM fee risk is different than portfolio risk, so they hedged the wrong risk. Also, by purchasing a deferred put, they ended up paying much more for the hedge than they should have due to the time-value embedded in put options.
I have designed a put-based hedge strategy that will effectively hedge the downside risk of AUM fee income as specified for a given period (e.g., one-year). By adjusting strike prices dynamically throughout the year to guarantee just the income specified, the strategy saves about 50% of the premiums, on average.
The recovery in stock prices from the 2008/09 financial crisis has run much longer than usual. While I am not predicting when the next downturn will occur, RIAs should protect their firms for the next one. Financial firms in a competitively strong position can use their income to market and add clients.
Cost-Benefit-Risk Analysis Steps
Step 1: Define Objectives and Performance Criteria
I believe that it is very important to clearly define and link the objectives of any hedging strategy or program to achieving the advisor's strategic plan and operating budgets. By doing so, the performance/evaluation criteria for the hedge program can be clearly defined. I believe the emphasis should be on meeting budgets and strategic plans rather than beating market benchmarks.
Having clearly defined objectives is key to not abandoning the hedge if prices temporarily go higher. It's also important to keep in mind that the AUM for the following year(s) can be hedged at a higher level if prices go higher and stay higher.
Step 2: Perform Risk Analysis
In this context, I define risk as the sensitivity of AUM income to price changes. The forward risk will depend on underlying portfolio allocations and assumptions about future price means, variances and correlations.
If there are many different assets in the portfolios, I recommend focusing on the systemic market price risk. The variance of the underlying portfolios to the market risk is known as the basis risk. As long as the basis risk is smaller than the market risk, hedging will reduce risk.
Step 3: Assess Risk Tolerances
One focus of this step is to assess how large a drop in income would interfere with budgeted activities and meeting overhead. The other focus is to assess how the advisor feels about different sizes of losses of AUM as well as different opportunity losses (hedge losses) if prices rise.
Step 4: Define Hedge Instruments and Strategies
The statement of objectives, the risk analysis and risk tolerances will jointly determine which hedge strategies and instruments should be analyzed. Considerations for types of hedge strategies are whether the strategy will be static or dynamic.
Static strategies are those that are initiated and completed regardless of market developments. Dynamic strategies are those that change hedge levels based on some pre-determined criteria, such as market valuation or risk preferences.
Hedge instruments may include futures, options and ETFs. Criteria for selecting the specific instruments should include hedge effectiveness, market liquidity (bid-ask spreads) and friction costs.
Step 5: Assess Risk/Return of AUM With Hedges
Just as in the unhedged risk analysis, the task is to develop scenarios as well as simulations for the forward budget and strategic plan periods to calculate the risks/costs/benefits of each strategy, as defined in the unhedged risk analysis.
Step 6: Compare Costs/Benefits of Hedged vs. Unhedged AUM Strategies
As a result of the steps above, a comprehensive quantitative and qualitative comparison of your choices is needed. Risk preferences need to be used to judge the overall costs and benefits of each strategy vs. not hedging.
Hedge programs, like any form of insurance, have an expected cost over time. However, if AUM drops as a result of price declines, they can provide positive payouts in those years when needed.
Hedging also helps the advisor avoid another potential conflict of interest. Often, advisors cannot charge AUM fees on assets sitting in cash. This creates a conflict if the advisor actively manages allocations and expects stock market prices to drop. By hedging, the advisor can move assets to cash in that case without losing AUM income if prices drop.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.