Monday, August 23, 2004

Comments on Points of Inflection/B-shares and Regulations

In my book The Pure Investor (have you bought one yet?), I didn't touch on choosing a share class. This has become quite a hot topic with various regulators and SROs. See here, here, and here, for a flavor.

Professionals in my field of investment advice sometimes feel like their being shot at from all sides. The markets are hurting them, clients are becoming more demanding, regulators are demanding more and more disclosure and seem suspicious anytime we get paid. Often times, what each of these groups want and need are in direct conflict with one another. I noticed such a case in a recent article by Peter L. Bernstein by the CFA Institute Conference Proceedings.

Mr. Bernstein lays out the problem as such:

The open-ended format of many investment managment relationships forces managers to look to the short-term only. Open-ended means that you can fire a manager easily - once a year - or in the case of a mutual fund, but you can hire and fire the manager daily by buying or selling shares. This open-ended format doesn't allow the manager to exploit long-term market inefficiencies, thus potential returns are being given up for the convenience of liquidity.

To quote Mr. Bernstein:

The open-ended really has two ends: one where money comes in and one where money goes out just as easily. As a result, managers are tied much more tightly to short-term strategies than they might like because they cannot persuade their clients to wait for the period of time that is required for a longer-term strategy to work out.
What's Mr. Bernstein's solution? He believes that managers should emulate hedge funds, real estate, and private equity. To quote:

So, how about a five-year contract that the client signs, but the client can purchase options to quit at the end of any year, with the price of those options declining year by year? IF a client wants to get out the first year, that option is very expensive. If the client wants to get out the third year, that option does not cost the client so much up-front. If the client wants to stay for the whole five years, the fee will be that much less.....The idea is to give the manager the money for an extended period of time so that the manager is in a position to make longer-term bets than he or she could under the open-ended format, where money can go out when the client chooses. That ability for money to come and go at will has to demand a price.
What Mr. Bernstein has decribed is what I would call silk handcuffs; they don't really hurt but they keep the client from hurting themselves. Another name for what he decribes is b-shares - exactly what the NASD is warning against inappropriate use above.

My main job as an investment advisor is to control my clients behavior. What Mr. Bernstein proposes helps do that as well as b-shares. However, if I use b-shares too much or what they term "inappropriately" I will bring down a world of hurt upon myself.

Conclusion: I walk a tightrope between doing what's best for my clients and what those that regulate me think are best for my clients. Who knows best? Me, but they sure do have a big hammer to hit me with if they disagree.