Bobroff:  I sure hope not, since most money management firms have a difficult time managing their business with traditional fee arrangements.  If we were to move to performance fees where earnings are hard to quantify it will be very painful. Public money managers will do anything to keep that from occurring.

Ellis:  Yes. I see a move to the following fee makeup:

1. A base fee for custodial services and reporting on assets of around 20 basis points
2. A fee for due diligence on managers of another 20 basis points in managed accounts
3. A fee for active managers of 35-60 basis points on managed assets
4. A transaction fee for individual trades in ETFs and fixed income
5. A risk- and style-based performance fee for both managers and advisors for beating pre-determined benchmarks
6. A fee for annual financial planning which will become mandatory for advisor-supported clients. This will be a stepped schedule based on asset size (starting at around $1,000 for a plan that is slightly better than one can get for free on the internet) and complexity of portfolios and tax and estate situations.

Advisors will be only working with high mass affluent and above clients in the future, and the mass market and most of the mass affluent will be in a self-service environment. Most wealthy clients need to be in models-based UMAs for the tax and trading efficiency benefits.

Roame: While I agree that investors may get frustrated by the lack of alignment in incentives between themselves and their financial advisors, I think too many experts predict too rapid an industry shift.  Some investors will move to performance fees, flat retainers, and other forms of compensation, but my guess is that 95% of financial advisors will still charge AUM-based fees.

Dunham & Associates, a San Diego-based advisor and fund manager, employs 100% performance-based fees.  Some customers will use them because they have the courage to do this.  It’s a great strategy, correct for some.

But this industry does not change quickly. AUM fees are ingrained into the fabric of asset management.  Retainer fees have the same issues.  A few advisors charge retainers, but the majority charge based on AUM.  It is unrealistic to pretend the whole industry will shift.

Bobroff:  Much like other specialty products of the past, they are not mainstream and thus it really doesn’t matter. The biggest problem with these strategies is trying to manage toward a specific benchmark while investors require liquidity and can demand their assets at anytime. These products work best when the assets are stable and not moving in and out.  They are really not ideal as a mutual fund.

Ellis:  I see some growth in this space, but more for the related “structured product” space.

Roame:  The term “hedge fund” has been bastardized. What we lump together as hedge funds is silly, since a highly diverse array of asset classes and strategies are included in the hedge fund category.  “Absolute return” is a better term, as it more precisely defines a strategy.

Absolute returns and more broadly non-correlated assets are likely to be a growing part of the investing market.  Consumers will seek out advisors and institutions that offer non-correlated assets.  These strategies will come back and grow within the 40-Act universe and among traditional hedge fund product structures.  Investors have paid such a dear price in the current market, and they want to believe that some smart guy can figure out how to properly diversify and reduce risks.

Bobroff:  I agree.  The managers of these products in general have failed to demonstrate that they can find the diamonds and leave behind the trash.

Ellis:  I agree.  Alternative investments do not always compensate appropriately for illiquidity. If you can’t get your money back, how can you say that you generated a positive return? The diversification of funds of funds has proven to be unreliable at best. The only advantage hedge funds have over regulated retail asset management is their ability to short equities. Therefore, they need a pool of long capital to short against. The most-likely victims will continue to be those poor suckers in Middle America with 401(k) accounts and mutual funds.

Roame:  I agree.  We have to be careful we don’t create some of these problems.  Funds of funds, when they started, weren’t understood.  Among hedge funds, there are single strategies, absolute return funds, distressed securities funds, convertible arbitrage funds, and a host of other strategies.  But the use of multi-strategy hedge funds of funds rarely makes sense, other than to help one’s ability to schmooze at cocktail parties.  Why would an investor choose such a product?  Why would an investor lump an absolute return fund and long equity leveraged fund in the same portfolio?  It may sound cool, but it is not justified by any valid investment principle.  Single-strategy funds of funds are logical depending on one’s risk profile; investors don’t need to bet on single managers.  I get that, but not multi-strategy funds of funds.   What is the risk profile that justifies that?  Or is it just another way to collect 2% and 20%?