Edition 53, Finance

Investment Advisors

By: Yolanda Espinosa
ITAM

The role of the investment advisor has gained considerable importance in Mexico in recent years. The total amount of assets under management has actually quadrupled in the last decade.

This amount stood at 113 billion pesos at the end of 20131, distributed in more than 4,281 contracts with various institutions of the financial system on behalf of clients, who may be individuals, private corporations and pension funds, among others.

Although they are not intermediaries of the stock market, investment advisors are of such importance to the Mexican financial system that the National Banking and Securities Commission (CNBV, acronym in Spanish) recently incorporated them as a monitored sector.

As of January 2015, investment advisors are required to be registered with the CNBV, an important step in providing certainty and greater transparency to the market. Both individuals and corporations must meet certain requirements and provide information proving their honesty as well as a manual of conduct with standards and policies to resolve conflicts of interest, operational, financial and administrative information related to the provision of its services, certification before a self-regulatory body, and other relevant factors to exercise their advisory functions.

Investment advisers are individuals and corporations that on a regular basis provide professional portfolio management services, for which investment decisions are taken on behalf of and at the expense of third parties, investment advice on securities are offered, analysis provided and personalized investment recommendations are made for each client.

Unlike a representative who serves the public on behalf of a financial institution, investment advisors establish a link and receive direct payment from the investor in exchange for their services. Securities transactions ordered by the advisor are documented in the name of the client, who must have an account or brokerage contract with an intermediary authorized to perform operations on the Mexican Stock Exchange (BMV) and provide the advisor a mandate that empowers him/her to give instructions in their name, or to authorize him/her in the contracts concluded by the client with the intermediaries.

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1> Mexican Association of Independent Investment Advisors A. C. The latest figure was released at the end of 2013, with assets under management totaling more than 113. 2 billion pesos.

The analysis that a client should conduct to choose and hire the services of an investment advisor is not limited to observing the historical returns that the advisor has generated from portfolios. The investor must primarily assess the transparency of the information provided by the investment advisor, paying attention to the scheme of remuneration and fees charged.

Investment advisors have various compensation schemes, although they generally charge a percentage of the value of the assets under management, AUM, for their services. Other common forms of compensation are fixed fees, hourly rates and commissions on securities traded under their advisory.

In addition, it is wise to check the following items:

  • Experience and technical knowledge in the field of investments
  • Certifications
  • Authorization by the CNBV
  • Major products and strategies
  • Main services
  • Sanctions and demands

The new regulation, along with the increase in information of the investment advisors and public statistics on this figure —nonexistent today— can help to reduce the information asymmetry and mitigate the agency problems that exist in this sector, as happens in many other contractual relationships. In this particular market, the client (owner of the assets) is the principal and the investment advisor is the agent.

The agency problems in this market are due to the client and the investment advisor having different interests, incentives, horizons, skills and information sets. In addition, the client has little capacity to monitor the advisor. Among the agency problems mentioned above, the two main ones are

  • Adverse selection. Adverse selection occurs when the client is unable to verify the competencies of the investment advisor. The advisor has more information than the client.
  • Moral hazard. Moral hazard occurs when the client cannot monitor the actions of the hired investment advisor.

Usually, there are several layers of intermediation between the investment advisor and the client, each with the potential to add conflicts of interest and commissions to the detriment of the interests of the client. To minimize agency problems and maximize shareholder value, the advisor can minimize the layers of intermediation and provide transparent information on potential conflicts of interest. Also, clients and investment advisors may enter into contracts or establish mechanisms to ensure that 1) the best advisors are willing to participate, and that 2) they are provided the appropriate incentives to work.

The best explicit contracts to mitigate agency problems are those that are based on results and that impose certain restrictions on investments —a way of defining the investment risk and universe— in accordance with the profile of each client. To some extent, the new regulation already addresses this last point. With the results-based contracts, the client and the advisor share the proceeds that are obtained. In a contract of this type, a fixed monthly or quarterly rate could be established and an additional bonus if the advisor reaches the goal, such as for example, a better performance than the benchmark index (setting an appropriate benchmark is very important and deserves further study). Another contract is that of relative performance, in which advisors are rewarded if their performance is superior to that of their competitors. With these schemes, if the investment advisor creates value for the client, that additional value is divided between the two in a kind of bargaining game.

In the particular case of clients who are individuals, Andrew Ang2 suggests that the best payment scheme for the advisor is a flat fee or an hourly rate. This is because the relationships between the advisor and the individual have several dimensions (at a level that is not usually achieved with a financial intermediary) and the advisor provides a variety of services. When agents must fulfill several tasks or it is not possible to quantify them, the best contract is that of a fixed salary with the portion of variable compensation either minimal or non-existent, because to encourage them in one respect can demotivate them from performing other functions. An example of this is when clients need advisors who accompany them, listen and guide them on various topics that are not directly related to their investments.

In this sector, implicit contracts are as important as explicit ones in virtue of the fact that the reputation of an advisor is crucial to winning new clients and keeping existing ones. This ability to win over new clients by having a good reputation in the market is a strong long-term incentive because, as stated, it dominates the compensation scheme with a fixed percentage over the total assets under management.

Although concern over their reputation drives advisors to do their utmost in providing their services, it can also have distorting effects when these specialists invest in portfolios similar to those of their competitors or with little deviation from the benchmark index so as not to endanger their reputation if an investment strategy fails.

In conclusion, while clients know that there are conflicts of interest in this field, as elsewhere, what is important is that the advisor disclose potential conflicts and that contracts, structures and mechanisms are defined in order to mitigate and resolve them in such a way that the interests of the client are taken into account and value is created

Bibliographic references

Ang, Andrew (2014). Asset Management, Oxford University Press.

Stracca, Livio (2005). “Delegated Portfolio Management: a Survey of the Theoretical Literature”. Working Paper Series No.520, European Central Bank.

Chevalier, Judith A., Ellison, Glenn D. (1995). “Risk Taking by Mutual Funds as a Response to Incentives”. Working Paper No. 5234 National Bureau of Economic Research.

Ley del Mercado de Valores del 30 de diciembre de 2005. Current text with the latest revision published on January 10, 2014.

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