The Investment Industry: A Basket of Deplorables?

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The Investment Industry: A Basket of Deplorables?

  • Knowledge Arbitrage: Works Against You
  • Incentives need to be aligned. Does your advisor make money when you trade?
  • Egregious Examples of Customer Betrayal
    • Churn and Burn at Dean Witter
    • Private Securities: 10% commission high enough?
    • High Cost S&P 500 Mutual Funds: Why do they exist?
  • Make Sure You Know How Your Advisor is Getting Paid

The very notion of capitalism is to trade value for value.  However, parts of the finance community have freed themselves from the uncomfortable position of having to create value.  Instead, they have mastered a shortcut: The art of re-distributing value from their clients into their own pockets while creating the notion in clients’ minds that they are in fact receiving fair value in return.

Knowledge Arbitrage

You might wonder how?  The issue comes down to what is known as “knowledge arbitrage.”  Consider your local mechanic having diagnosed the problem to be a failed cylinder head gasket, typically a somewhat expensive fix.  How can you know if that is in fact true or not?  Likely, you are not the expert. Worse, you know you and your car guy are subject to opposing incentives: The bigger the job for him, the better for him and the worse for you. We all know the feeling: We don’t trust what they are telling us, we have no way of checking without undue effort, so we finally talk ourselves into believing that they are likely better people than they are.  After all, he has those cute pictures of his family on his desk. Must be a good man.  Plus, I am pretty good at catching liars and he is just not the type…

 

Over the years, financial regulators have shut down the most egregious schemes. Yet, we are constantly learning about another scandal by a blue chip firm. The latest perpetrator betraying investor trust is no other than the previously well-regarded financial institution Wells Fargo.  We vividly remember a friend of ours explaining to us six months ago why Wells Fargo is the best-run bank in the entire country, or so he and many others thought!

 

Last week we wrote about knowing if you can trust someone.  We stressed that in addition to the three main character traits (reliability, truthfulness, and trustingness) there is one additional factor that must be considered, incentives.  When incentives are aligned, it is much easier to trust someone.  When incentives are not aligned, you have to watch out, even if it is someone you really trust.

Incentives Must Be Aligned

The money management industry can work against you when your incentives are not aligned with the incentives of your broker/advisor.  When the person advising you and managing your money also makes money on your trades, your incentives are not aligned.  In our industry there are two vastly different business models, which pretty much look the same to the unsuspecting general public: (i) Broker-Dealers (BDs), and (ii) Registered Investment Advisors (RIAs).

 

The Broker-Dealer gets paid whenever you transact (buying or selling a security) and also may receive ongoing payments from funds he/she has placed you in.  The Registered Investment Advisor is paid a fee by you for managing your money but is paid nothing when you transact and receives no ongoing fees.  Some firms double dip and act as both (hybrid BD/RIA – arguably the worst for clients). You might find it surprising that almost all of the large brand name firms in our industry are broker-dealers or hybrids, directly pitching their employees’ incentives against yours.

 

We are a pure play registered investment advisor at Carden Capital.  Therefore we do not make money on any trades that our clients make nor do we get paid any ongoing commissions on mutual funds we sell to our clients.  This assures our alignment of interest with our clients.  Our wealth management portfolios are designed to reduce the costs and trading as much as possible so our clients keep as much money as possible.  However, if we were part of broker-dealer, we would do things differently?  Potentially.  We would have all sorts of financial incentives to do things that made ourselves more money, and our clients less money.  As long as we could justify it to ourselves, then we would probably go with it.  This is what happens when incentives are not aligned.  We’ll share several examples that prove our point.

Churn and Burn at Dean Witter

Our first story takes us back to 1994.  Sean Wright is working as an intern at the offices of Dean Witter (now part of Morgan Stanley).  While he was busy cold calling wealthy Californians to generate business for the firm, he is listening in to a senior stock broker (that’s what they used to be called) working his clients for business.  “Hello Mrs. X, this is Bob from Dean Witter.  I wanted to let you know that McDonald’s missed its earnings by two cents today and the stock is down.  I think you should probably sell it.”  Pause on the line…Bob not looking happy…tries for the save…Bob slams the phone down.  “Fxxxing Bxxxx!”  Sean was young and inexperienced, but he could tell that Bob was doing something that was not in his clients’ best interest.  It turns out what Bob was doing is illegal.  Bob was trying to churn his clients’ accounts, meaning have his clients engage in excessive buying and selling so he could generate more commissions for himself.  While regulators have been clamping down on this particular practice, there are plenty of other legal ways to fleece clients.

Private Securities: 10% commission high enough?

Pretty much anyone you come into contact with these days who acts as a financial advisor is going to be approaching you as a hybrid BD/RIA.  The idea here is a bit different.  Essentially the broker/advisor you work with operates with under both regulatory regimes, first as a broker (making commissions on your trades), and secondly as an investment advisor (making a fee for “managing your money”).  In this case the broker/advisor has the best of both worlds.  He makes money on your trades and makes money on your money, which usually provides strong incentives to place you in the products with the highest commission for the broker.  The incentives are clearly not aligned and the outcome can be really bad.  If you don’t believe, us we have another good war story for you:

 

Last year we were introduced to some wealthy entrepreneurs.  They had recently sold a technology business and wanted to start another tech business.  So they took a portion of their proceeds and set this money aside to fund their next venture.  They gave the broker/ advisor specific instructions that this money was to be used to fund a company and would be drawn down as cash was needed to fund the burn rate.  The money was to be invested conservatively and with an eye on liquidity so that they could draw on the cash whenever needed.

 

When we got in contact with them, they had liquidated 70% of the portfolio and had another 30% that apparently “could not be sold.”  We asked them why.  They said, our financial advisor said we can’t sell this.  We were highly suspicious.  It turns out the financial advisor had put 30% of the money in private REITs and private BDCs, which are private investment securities with little or no liquidity.  Interestingly enough, these particular private securities also pay a 10% sales commission, and the maximum percentage that this broker/advisor was allowed by his broker-dealer to place in a client portfolio was 30% of the portfolio, which he did.  The broker/advisor in this particular case made a six figure commission payment on the deal, and then turned around and charged the client a 1% advisory fee every year to manage their investments.  Even better, the clients could not sell the investment so he could keep charging his 1% every year.  To make matters worse, this broker/advisor had worked with one of the entrepreneurs for ten years prior and was a “trusted advisor.”  Clearly the broker/advisor had not followed his client instructions.  The money was too big and the incentives were too misaligned, so the trusted advisor betrayed the customer.  The broker-dealer involved in this case has been sued multiple times for similar instances.  Naturally, we are talking about a large blue chip firm!

High Cost S&P 500 Mutual Funds

Here is our last example.  Most folks know that the S&P 500 is a market capitalization weighted index that is very easy to replicate.  You can buy a mutual fund or ETF at a very low cost (under 0.1%) per annum that replicates this index for you.  You might be surprised to learn though that there are over 40 mutual funds that replicate the S&P 500 index but not all of these have really low fees.  Why would this be the case?  Because brokers get paid ongoing fees for having you placed in a mutual fund.  These are called 12b-1 fees.  The two most expensive funds are the QS Batterymarch (a Legg Mason company) S&P 500 Index Fund which costs 0.59% per annum and the MainStay (part of NY Life) S&P 500 Index Fund which costs 0.60% per annum.  The QS Batterymarch fund has $239 million in assets under management and pays 0.20% per annum in 12b-1 fees.  The MainStay fund has $1.55 billion in assets under management and pays 0.25% per annum in 12b-1 fees.  Is there any reason for these funds to even exist?  If the market were efficient and brokers had to abide by the fiduciary standard, they would not exist.  But many broker/advisors will place clients in these products in order to get the payment they would not otherwise receive if the client were in a low cost fund.  There are many similar examples in the security industry and quite often your broker/advisor does not have an incentive to put you in the lowest cost product if they are in a position to receive a trailing commission to have you placed in a product.

Make Sure You Know How Your Advisor is Getting Paid

The logical conclusion for the client is clear.  You need to know exactly how your broker/advisor is getting paid in order to avoid a misalignment of incentives that can cost you dearly.  If your broker/advisor gets paid when you transact, his/her incentives are not aligned with yours.  If your broker/advisor gets any ongoing payments from a fund he/she has placed you in, your incentives are not aligned.  The only true alignment of incentives is when you work with a pure play registered investment advisor who is only paid by you for managing your money and nothing else.

 

Before we ever start a new client relationship, we perform a cost/benefit analysis of the current holdings and estimate ways to save money.  If you have your money with a broker-dealer or hybrid broker-dealer/RIA you may want to have us take a look and let you know if you are getting the best bang for your buck.

 

Finally, let us apologize to all of our friends who work for broker-dealers or hybrid broker-dealer/RIAs.  We know many of you do good work.  We do not intend to personally insult you or your integrity.  There are good actors in the business, but it is easier to be a good actor when you have the right incentives.  We are looking for talented advisors that are good actors to join our team.  If you would like to be a part of a team that puts the client first, contact us.

 

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