The Globe and Mail, Report on Business
Published August 8, 2009

It may not be politically correct to admit it, but I have mixed feelings on the billions of dollars worth of bonuses being paid out on Wall Street.

I'm always wary of hysterical, highly politicized issues that have only one side to them. But in this case, I've actually lived the other, less obvious side. For years, I managed people on the sell and buy sides of the Street, so I can appreciate the bind Wall Street executives are in. While overall corporate performance is abysmal, they need to keep their good people in place – the individuals, teams and departments that didn't screw up or rip off clients, but instead performed well and delivered much-needed profit to the bottom line. If they don't pay these top performers, there is sure to be another company that will.

When discussing the bonus issue, it's important to distinguish between the directors and senior executives who are responsible for the overall organization and their high-priced help. Compensation for top executives must be aligned with the accomplishments of the firm. Losses and government bailouts mean no bonuses, period.

But in the case of the high-priced help, the top guns, a difficult balance needs to be struck between corporate results and paying for individual performance. In the fairy tale world of Wall Street, that means seven-figure cheques for some.

Why the mixed feelings then? Because even after a near-death experience, the investment industry is still disconnected from reality, and many of the bonus decisions are ridiculous. In general, the industry's compensation model is taking too large a chunk out of client returns. And make no mistake, we need to look at it in those terms. Every dollar paid for a service is a dollar not available to make pension payments or RRSP withdrawals.

Rather than legislating executive compensation and trotting everyone to Washington, I have another solution.

I hereby propose that investors, whether they be individuals, corporations, pension plans or governments, be more discriminating when purchasing financial services. Be it resolved that they will ask questions, explore lower-cost options and be willing to say no more often.

When it comes to asset management, investors should expect to pay a premium for some services. They should be willing to pony up for a highly regarded portfolio manager who can only handle a limited number of assets. This particularly applies in asset classes where there is potential for higher returns but a limited supply of investments. At Steadyhand, we charge our highest fee on the small-capitalization equity fund (1.7 per cent), primarily because it has a predetermined limit on its size.

In areas where the cost of fund management is higher – such as real estate, infrastructure and other types of private equity – fees have to be higher. There is considerably more legwork and administration involved in making the investments.

But there are still far too many instances where clients overpay needlessly to have their assets managed. Canadian investors are still paying 2.5 per cent to own mutual funds that do little more than mirror the index.

Investment returns can be broken down into two components: the market return, or “beta,” as it's referred to; and the added value derived from active management or “alpha.” Beta is cheap. Market exposure can be bought through an exchange-traded fund (ETF) for a fraction of 1 per cent. Alpha is more expensive, but if the manager isn't actively pursuing it, then the fund is a commodity and should be priced as such. Alpha-like fees for beta-like products contribute mightily to bonus pools.

In performance-based fee arrangements, investors often accept too generous a base or minimum fee. Asset managers who want a piece of the upside should have to share in the downside too. In the hedge fund world where these arrangements are most common, the standard is a 2-per-cent base fee and 20 per cent of any profits. For clients willing to share the spoils with their manager, 2 per cent is too high a retainer. There shouldn't still be a bonus when managers don't perform.

One of the buy side's dirty little secrets is the pricing of balanced or diversified funds. These have a large component of cash and bonds (40 to 60 per cent), assets that should garner a considerably lower fee. And yet these funds are often priced in line with pure equity funds. The premium fee might be justified if managers were more active in adjusting the asset mix, but most balanced funds don't stray far from their long-term target (i.e. 60 per cent equities, 40 per cent bonds).

The math demonstrates what I'm saying. If we assume the fee for fixed income is 1 per cent (which is generous), then it works out that a 60/40 fund with a 2.5-per-cent fee is charging 3.5 per cent for the equities. Clients can easily construct their own diversified portfolio by holding individual funds and thereby reduce their cost and reclaim some of the industry bonus pool.

Instead of letting governments make a hash of regulating executive compensation, it's time these firms' clients take some responsibility for reducing the bonus payouts. As rocker and poet Patti Smith says, “People have the power.”