Saturday, March 16, 2013

Changes in the Financial Services Industry and the Rise of the Fiduciary

From 1948 to the early 1980s the financial industry in the U.S. generated from 5 to 15 percent of all U.S. business profits.  In the early 1980s this started to creep higher and higher.  In fact, at one point, early in this 21st Century, financial sector profits reached over 45% of all domestic corporate profits.  While subsequently financial services industry profits declined, and were even negative for a short time, they have returned to levels that seem nonsensical.  In the United States, financial sector profits now have returned to between 30% and 40% of all corporate profits.

As stated in economist Simon Johnson’s seminar article, The Quiet Coup (2009): “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.”

How has this occurred?  Why is such a high level of rent extracted from the U.S. economy by the financial services sector?  And will this high level of division of the returns of the capital markets, away from individual investors and to financial services intermediaries, continue?

I would note that the process of capital formation, and investing, from 1950 to the current day, became both more complex and simpler.

There was a time when individual investors relied upon brokerage firms to put together a portfolio of individual stocks.  Brokerage firms and their representatives were hired on the perception as to whether their analysts could “beat the market.”  Advertising campaigns persist to this day which tout stock-picking expertise, although perhaps not of the type seen when everyone in the commercial became silent when the E.F. Hutton broker spoke.

Stock brokerage commissions, once the main source of broker's compensation, were effectively deregulated in 1975.  This began the meteoric rise of pooled investment vehicles.  Broker-dealer firms and their representatives, unable to make high profits from commissions on stock sales, turned to the manufacture and sale of mutual funds and other pools of investment assets.  While extremely high commissions for the sales of mutual funds persisted for a while, eventually limits on commissions were adopted (although they still remain high).  In addition, broker-dealers and product manufacturers adopted means to hide from investors payments by product manufacturers to product distributors, such as by payment of soft dollars, payment for shelf space, and directed brokerage.  These means persist to this day.

In the 1990's, with the continuation of the longest bear market in U.S. stock market history, mutual fund managers began to be worshipped.  Television shows appeared in the 1990’s in which fund managers were routinely interviewed and star fund managers were recognized.  Brokerage firms employed analysts themselves, to pick managers more likely to outperform in the future; these analysts – when they were correct – were likewise promoted by the media as "star analysts."

Concurrent with all of these developments, over the past several decades we have seen the rise of Modern Portfolio Theory (MPT).  With MPT came the realization that diversification was a means of eliminating uncompensated risk.  Subsequently, the Efficient Markets Hypothesis indicated that active investing was a “zero-sum game.”  Subsequent academic studies continue to indicate that, especially over long time periods, passively managed low-cost investment pools outperform (on average) actively managed higher-cost investment pools.  As a result, and especially over the past decade, index funds, assisted by passively managed ETFs, have grown substantially in popularity.  Active management continues to dominate; since there are so many forms of active management it can never be "disproven."  Yet the trend toward passively managed, lower-cost pools of investments continues.

In the late 1970’s defined benefit plans hit their peak in terms of the percentage of employer participation.  Since then, defined contribution plans and individual retirement accounts have over time slowly, but inextricably, replaced defined benefit plans – a trend which continues today.  More and more individual investors became required to manage their own stock portfolios - which previously had been done for many of these individual investors, out of their sight and out of mind, by defined benefit fund managers.

So, looking back, in the mid-1970’s traditional Wall Street firms, lost the fixed and very high, commissions for stock trading.  To replace sources of revenues firms turned to the manufacture, promotion and sale of investment products, mostly of the pooled investment variety.

Yet, under pressure from investors who shied away from proprietary products, over the the last decade many of the large Wall Street firms – but not all – have shed their asset management divisions, selling off their portfolios of proprietary mutual funds.  But many proprietary products remain.

With the continued evolution of technology and competition from discount brokerage firms, profits seen in trading on an agency basis have continued to decline.  To restore profits many Wall Street firms greatly expanded their principal trading operations.  Of course, the expansion of these operations created more severe conflicts of interests, and exposed many firms to new types of risk which they failed, in many cases, to successfully manage.

There is no doubt that, for individual Americans, the financial world became more and more complex.  No longer do most Americans in retirement head to the mailbox for their monthly pension check.  Instead, individual investors possess the solemn responsibility to save, invest, and manage portfolios for the purpose of achieving their lifetime financial goals.

Because there exists such asymmetry in the information between financial product providers and individual investors, in many instances individual investors were sold high-cost investments.  Even today, investment products continue to be sold which possess enormously high rent extraction, driven in large part by huge advertising and promotional budgets of Wall Street’s firms.

Yet, now we appear ready to enter a new age.  Call it the age of the trusted advisor.  It is the age of fiduciary advisor, who represents only the individual investor, and not the product manufacturer.  It is the age where an advisor says, "I will step into your shoes, with my knowledge and expertise.  I will act for you, or advise you, as I would advise myself, in return for a reasonable fee."

In the past few years, it has also become increasingly acknowledged that many types of investments are commodities.  (For a clear example - index funds.)  At financial advisor industry conferences more and more discussion has occurred of the "commoditization" of investments, and forward-thinking financial services bloggers and journalists continue to write articles on this theme.

The result of these trends is disintermediation.  But the dinosaur called Wall Street will not fall down without first thrashing out.  It seeks to preserve the investment product sales model, despite its many conflicts of interest, its high costs of intermediation, and its unexplainable inefficient and high extraction of rents.

Direct sales to consumers continue to expand, such as from discount brokerage firms and low-cost mutual fund complexes.  Much of this occurs because individual investors, often repeatedly burned when dealing with product salespersons only to have their trust betrayed, have eschewed all providers of financial and investment advice.  They simply believe, in some instances, that "investment advice" is not worth paying for, and they guide their own portfolios (aided in many cases by an increasing amount of investment literature - some good, but much of which is awful).

While individual investors possess the power to effect disintermediation, they do not always possess the knowledge to effect that change.  Hence, many more investors remain trapped, by their own ignorance, within the investment product manufacture and sales business model.  Recent studies have revealed that nearly one-third of individual investors believe that their "financial consultant" does not charge them any fees at all, and that they are receiving advice that is being delivered gratuitously.  If only they were so lucky.

Yet knowledgeable investors exist.  Increasingly, and with the assistance (in large part of) independent journalists and others in the media, individual investors are looking for those few financial advisors who possess very few conflicts of interest. (Many are directed to for fee-only financial advisors, and to Garrett Planning Network - whose members often provide hourly-based financial advice.)   In essence, individual investors recognize that, in this complex world, the guidance of a true professional is both needed and desired, and they are willing to pay reasonable compensation for same.  And, with education, these individual investors learn that they will actually save money, often substantially, by having an advisor who assists them to choose lower-cost products.  How much is the net savings to investors, relative to the product-sales (broker-dealer) channel?  30% to 70%, in many cases.  Enough for a comfortable vacation once a year for the client, in most cases.

This brings us to the rise of the fiduciary advisor, and specifically the recent expansion of the registered investment adviser (RIA) community.  In recent years a trend has emerged in which individual investors seek out true fiduciary advisors, leading to this expansion.  This form of remediation is positive, as the costs of remediation are far less than the costs saved from disintermediation (despite unsupported statements by Wall Street firms to the contrary).

Of course, there is resistance to these changes from the old business model of investment manufacture, promotion and sales.  And deception also has increasingly taken place in an effort to preserve the high profits of the product-sales business model.  For example, many financial advisors promote themselves to consumers as “fee-based advisors” while never mentioning that they also sell products for commissions.  Instead of “V.P. Sales” on a business card, the term “financial consultant” has become commonplace for the product salesperson.  Disappointingly, federal securities regulators have failed to address these deceptive sales practices (despite the many warnings against such deceptive sales practices in prior decades from these same regulators).

Who will prevail - the old business model of product manufacturer and its sale through sales brokers?  Or the new business model - in which professional, independent, and trusted advisors use their knowledge to identify lower-cost investment products?

The answer remains unclear, here in early 2013.  Tens of millions of dollars are pouring into Washington, from economic interests determined to preserve the old business model.

But, as I will discuss in a future blog post, there are a courageous few – in Congress and in the halls of government agencies – who seek to aid in the transition to a new “fiduciary society."  They desire their fellow Americans to receive the truly objective, unbiased advice which Americans deserve.  They desire that the returns of the capital markets flow again in greater quantity to individual investors, not Wall Street's intermediaries.  They know that effecting such a transition can fundamentally restore trust in capital formation, leading to a new era of U.S. economic expansion and prosperity for all.  They realize that the imposition of fiduciary status on all financial and investment advisors is good not only for individual Americans, but for America itself.

I'll discuss one such courageous pioneer in my next post.  Stay tuned.

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  1. Think back to the first time you ever heard of Financial Planning. At one stage or another, every man woman or child will be faced with the issue of Financial Planning. While it has been acknowledged that it has an important part to play in the development of man, several of todays most brilliant minds seem incapable of recognising its increasing relevance to understanding future generations.

  2. Hey Ron,

    Very insightful post. You've definitely raised some great points, and yes it seems very nonsensical that US financial sector profits are currently back in the range between 30-40% of all corporate profits, as you've alluded to. I believe it's a combination of relatively strong US markets coupled with the fact that financial corporations are turning to financial services analytics solutions to help them make extremely informed decisions 6, 12, 24, and 36 months down the road. Big data is here to stay, and those that are embracing it and using it to their advantage are turning in large profits.


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