Tuesday, April 1, 2014

Wall Street's Dual Registrants Enhance Their Form ADV Part 2A Disclosures!

March 31st was the deadline for registered investment adviser firms, including dual registrants, to file their annual amendments to Form ADV, Part 2A. To my utter surprise, several Wall Street firms, apparently under pressure from the SEC’s Division of Investment Management and OCIE, substantially revised their SEC disclosure documents. These Wall Street behemoths now provide much more candid disclosures, written in plain English. Following is a compilation of these new disclosures from the major Wall Street firms.

In addition to our investment advisory fee of up to 2% a year, we receive additional compensation from the mutual fund companies and other product providers that we recommend. These include: (A) 12b-1 fees of up to 0.25% a year, which are marketing fees paid out of the mutual funds which do not benefit you as a fund shareholder; (B) revenue-sharing payments, of 0.18% a year, usually paid out of each fund’s management fees; (C) mutual fund sponsorship of our sales conferences and events at such conferences, so that our firm’s expenses are substantially reduced; and (D) mutual fund sponsorship of educational seminars for potential clients of the financial advisors of our firms. These additional fees and compensation are significant. So much so that we don’t permit mutual funds that won’t pay us these additional funds to be utilized as part of this investment advisory program. In other words, we will not recommend excellent mutual funds to you, because they don’t pay us all of these extra fees.

We also receive brokerage commissions from the funds we well. These often-high brokerage commissions include “soft dollars” which ostensibly compensate us for the investment research we provide to mutual fund companies. The fact that many funds pay millions of millions of dollars in high commissions for research which they could replicate within their fund complexes at a fraction of the cost does not disturb us, for our culture is very much a “scratch my back, scratch your back” culture.

None of these additional fees and costs will provide any benefits to you as a fund shareholder. In fact, the sum total of our advisory fees, and the additional fees and costs, you incur is likely to be substantially over 3% a year. Academic research shows that there is a 99% or greater probability, over any 20-year investment time horizon, that you would be better investing in a low-cost index fund, rather than pay these higher fees.

We also need to advise you that our investment strategies are seldom based upon sound academic research. In fact, we have little regard for the academic evidence regarding investing. Instead, we promote mainly actively-managed investment portfolios, since we can seek to better justify the high fees and costs paid by our clients. Moreover, most of the stock portion of the portfolios we recommend to clients have a large-cap and growth tilt. While this is contrary to over two decades of academic research which demonstrates that small cap, value-tilted stock portfolios possess an extraordinarily high percentage of outperformance over longer time periods (10 years or longer), our “financial advisors” are seldom adequately trained in the academic research regarding investment strategies. And do they possess any training to ensure your portfolios are designed and managed tax-efficiently? Don’t count on it!

We utilize a lot of “alternative investments” – many of which later “blow up.” While we undertake a minimum amount of due diligence to satisfy our obligation to recommend suitable products to our customers, in reality we don’t really lift the hood of these products and do through inspections. When these products blow up, we’ve already reaped high fees for them, and providing compensation to those clients who both to proceed against us in arbitration is just a cost of doing business. While complaints against our financial advisors forever tarnish their individual reputations, we don’t really care about that, as we are constantly recruiting replacements. And we don't really care about our current advisors' reputations ... what is a little mark on their U-4s for the rest of their lives?

While we are your “fiduciary,” in this disclosure document we disclose away our conflicts of interest. Even though fiduciary duties under the common law in most states require us to remain substantively fair to you, even when a conflict of interest is present, we couldn’t make more money without doing harm to you.

Our fiduciary duties, as an investment adviser (dual registrant), would require us to act in your best interests. While we always profess that “our client’s interests always come first,” in reality we don’t really care about you. We look for more and more ways to extract fees from you, in ways that you are not aware.

Speaking of which, we recently found a new way to extract fees from you. The New York Stock Exchange imposes fees upon transactions which are much higher than necessary to pay the Exchange’s expenses. As a member of the Exchange, we receive substantial rebates, usually tens of millions of dollars a year. Yes, this practice is seemingly anti-competitive and collusive, but who cares?

We also love to engage in principal transactions with you, even though we are a fiduciary. Why? Because we make a great deal more money in this way, rather than through agency trades. Yes, you may pay a higher price for purchasing a bond in this manner, on average, but that’s not our concern.

Now, I know you might be thinking, as our client, that you thought you could trust us. Because, after all, we are a fiduciary to you. And you can trust us. Even though we disclaim our fiduciary duties in our client agreements with you, and attempt to disclose away our conflicts of interest. So what if this means that you need to practice “caveat emptor” again. Chances are, you won’t. In fact, we have tons of research that, once we establish a relationship of trust and confidence with you, you’ll likely overlook our many disclaimers and transgressions. We know you won’t read all of the disclosure documents we send to you, which only casually set forth our conflicts of interest anyway. And even you read all of these disclosures, we know you won’t understand them. In fact, we are aware of all the behavioral biases that prevent you from protecting yourself, and our financial advisors are trained to take advantage of you.

Yes, you need a trusted advisor to this complex world of the capital markets. We are your trusted advisor. Just be aware that, while our advisors use titles such as “Financial Advisor” and “Wealth Manager” and “Financial Consultant” that indicate advisory relationships, and even though we are dual registrants, you really can’t trust us.

Of course, we are heavily regulated. By FINRA, an organization which is controlled by its members, and which has resisted raising standards of conduct for more than seven decades. Yes, FINRA recently warned about conflicts of interest and cautioned firms to act in the best interests of their clients. But in over a hundred pages of pronouncement, you will never see them utter the word “fiduciary.” Because we control FINRA, our self-regulatory organization. Even if FINRA fines us, the fines just help reduce our membership fees.

And we are heavily regulated by the U.S. Securities and Exchange Commission (SEC). But we have “regulatory capture” over that agency, as well. How, you might ask? Primarily because we continue to recruit SEC staffers to work for us. We essentially utilize the SEC as a training ground for our compliance departments. And, since SEC staffers know we pay so well, they have little incentive to “rock the boat” and investigate us and our transgressions.

And when our senior executives depart to work for the SEC, we often confer upon them extravagant bonuses. Because we want them to remember who really pays them. And, of course, we either expressly or by implication make certain they are aware that a job waits for them, after they finish their stint at the SEC.

You would think the U.S. Congress would get wind of this, and put an end to it. You’ve got to be kidding. Everyone knows that, though our massive campaign contributions to, and fundraisers for, members of Congress, and our huge number of lobbyists, the U.S. Congress is also controlled by Wall Street. In fact, many of the bills that are introduced which affect financial services are actually written by our lobbyists, as well as those occasional letters from members of Congress or their committees which profess to express outrage when the occasional staffer at the SEC or DOL actually seeks to do his or her job.

You might think that investing is all a game, which we control. And that this game is largely rigged by we Wall Street firms, to ensure that a substantial portion of the returns of the capital markets flow to us, rather than to you. And you are right.

We now seek a new “federal fiduciary standard” – essentially the super-weak suitability standard that ensures we cannot be sued for negligence, plus some casual disclosures. In other words, we want you to know that we are “trusted advisors” and heavily regulated. But all this amounts to is an “illusion of protection” – which we acknowledge is probably worse than no regulation at all.

Of course, we could tell you that there are independent financial advisors, working in independent broker-dealer firms and in fee-only RIA practices, that actually do work in your best interests, charge lower fees than we do, use academic research to construct prudent portfolios, and provide significant value. But, we don’t want you to know about them, of course. Rather, through our massive marketing efforts, we want to ensure that you believe that we are there to help you.

Yes, our advisors are departing us in droves, mostly due to the fact that we force them to utilize either proprietary products or mutual funds that provide us with substantial revenue-sharing payments of some form. While many of our advisors are fleeing us, so that they feel better about going to work each day, enough stay, and we recruit many more (asking them to sell to a list of 100 friends and family, first, our costly products).

While our market share continues to decline, we remain oblivious to the fact that our business model is nearing an extinction event, as our heads are stuck in the sand. With the aid of FINRA, the SEC, and Congress we will ensure regulations are adopted that permit us to continue our deceitful practices. It is so very important that the fiduciary standard be adopted to permit our business practices to continue. Heaven help us if the fiduciary standard is ever considered to be a restraint on our greed.

In summary, we tell you that we are fiduciary, trusted advisors. But we really are not. Don’t trust us.
And we tell you that the SEC is there to protect you. Of course, all the SEC is good for is protecting our archaic business model.

And we tell you that FINRA is there to protect you, also. What we don’t tell you is that F.I.N.R.A. really stands for “Full Insulation for Numerous Reps from Accountability.” Yes, FINRA is the worst regulator in the world. But it’s our primary regulator, and we control it, so we don’t mind.

Happy April Fool’s Day.

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