So I held an online Series 65/66 class today, and one of the attendees typed a message through the chat window that nearly sent me falling out of my chair. His question, essentially, was this:
I am currently in the process of registering my firm as an RIA. For the past few years I have been trading the online accounts of several friends, who gave me trading authorization. I don't charge any fees; instead, when my friends take their profits, they cut me a check for my share of those profits. This is okay, right?
My response was a little bit nicer than this, but essentially I wrote:
Uh, no, that's about as far from okay as you can possibly get. Why? First, if you're being compensated to manage your friends' accounts, you are an UNREGISTERED investment adviser. Even if you were registered, you can't share so-called "profits" with your clients based on gains on particular stocks. Why not? Because they aren't profits! If you put your friend into, say, 10 stocks, and one of them goes up 200%, you might think of that as a "profit," but what if the other 9 stocks drop 90%? Your friend is losing money big time. If the math doesn't jump out at you, let's try an example. Your friend has $100,000 in 10 stocks, $10,000 for each. One of those stocks goes up 200%, taking it up to $30,000. He sells and gives you a percentage of that, so he's made a "profit" of less than $20,000. The other $90,000 invested is worth only $9,000, now that those stocks dropped 90%. So, where's this "profit" you guys are talking about? YOU made a profit--your friend has lost in the neighborhood of 70-80% of his investment, depending on how much he shared with you. Hey, some friend you are!
That's why advisers get paid a percentage of assets--the whole account, not a percentage of the rare stock that happened to go up. If an adviser wants to share in capital appreciation, he has to use an index that represents the makeup of the client's portfolio, and if he meets or beats that index, then he can get a performance bonus. But, if you think that selling one stock for a gain is the same thing as a profit, you must believe that the stocks that have dropped 90% or more are just "paper losses." As if all stocks have to come back to your purchase price. The NASDAQ (qqqq) used to be at about 5,000. Now, almost 10 years later, it has not even come back to half that value. We could call it a "paper loss," just like we could call Sara Palin a thinker. Wouldn't make it true.
Even if you were doing performance-based compensation the right way, your friends would need to have at least $750,000 under your management, which I doubt is the case.
So, as Marsellus Wallace tells Butch in Pulp Fiction, this is pretty ******** far from "okay."