The End of Wall Street; The Emergence of a True Profession

There exists a stark reality facing the broker-dealer and insurance industries. It is found in the truths confirmed by academic researchers around the world and widely known by fiduciary investment advisers:

• Fees and costs matter. The higher the fees and costs, the less the returns of the capital markets flow to the contributors of capital - the owners of stocks, bonds, mutual funds, and other pooled investment vehicles and securities. Academic research in this area shows a direct correlation between higher fees and lower investor returns. The research is compelling ... and I would say, conclusive.

•  [THE HORSE RACE ANALOGY. This is not to say that, for a short period of time, a high-priced investment product might outperform. Take a horse race. To make the race fair, all of the jockeys and their gear must amount to the same weight. Those with less total weight have additional weight added to the saddle bags. But, suppose a horse is saddled with 25 pounds of additional weight, relative to all others. Does that mean the horse might not win the short race? No ... because by luck the horse might have a very good day, that particular day. But the weight matters much more as the race gets longer. It is highly unlikely that the race will be won by the horse with the added weight, as the race stretches to a mile, a mile-and-a-quarter, or even longer. And so it is with product fees. The higher the costs of products, and other fees extracted, the less likely the product will outperform over the longer term - whether it be 5 years, 10 years, or more.]

• [HEDGE FUNDS. Some in the world of finance might want to point to hedge funds as an exception to the rule that high fees and costs matter. Yet, more recent databases have been constructed of hedge fund returns which have less survivorship bias. The result should not be surprising. On average, hedge funds underperform index funds by a significant margin.]

•  [RISK AND OTHER FACTORS IN INVESTING. Some in the world of finance might desire to show that managers employing various risk factors (i.e., the value premia, risk premia, for example) or other factors in investing often outperform (over long periods of time) managers who do not. They will even point to Benjamin Graham. Yet, many of these factors are available to investors through low-cost index funds or other low-cost passive funds that capture the factors, at least to a degree.]

• Wall Street extracts excessively high rents. It is commonly known that many broker-dealer firms possess a target for client revenue equal to 2% a year of the investment assets upon which they provide advice. For insurance company products, such as variable annuities with GMWB and similar riders, the fees and costs often amount to 4% a year or greater. Yet, the large broker-dealers and insurance companies do not add sufficient value for these high fees. I estimate that 99% of the investment and insurance products they promote under the weak "suitability" standard won't survive the cost-benefit analysis undertaken by a true fiduciary.

• Economic incentives matter. If either firms or their employees possess incentives to promote a product that pays higher compensation, these incentives are too tempting. Higher-cost products are sold, far too often, when far better products are available. The fallacies of human nature are well known - hence, the reason for the strict application of the fiduciary duty of loyalty.

• Commission-based compensation is usually unreasonable compensation. A person rolls over a $400,000 401(k) account to an IRA, and is sold a variable annuity which provides the broker/insurance agent's firm a 5% (or higher) commission (in addition to other fees, such as 12b-1 fees and/or variable annuity trails). Simply put, a $20,000 commission, for a product that fails to survive due diligence in most instances, is wholly unreasonable. And the fiduciary standard of conduct requires that the fiduciary's compensation be reasonable.

• Commission-based compensation is contrary to the proper way to manage an investment portfolio under Modern Portfolio Theory. Whether one undertakes strategic or tactical asset allocation in the management of a client's investment portfolio, rebalancing of the portfolio must take place. This requires some of the client's investments to be sold, and new investments purchased, to rebalance the portfolio - often on an annual or other periodic (or targeted) basis. Yet, brokers often argue that commission-based compensation, such a those found in Class A mutual funds, is cheaper over the long-run for a client. How can this be, if proper fiduciary management of an investment portfolio requires periodic or targeted rebalancing?

• I question the validity of the broker's argument that Class A funds are "better" for clients, given the long-term impact of a sales load on investment returns. The impact of these up-front fees lasts forever. This impact is still substantial after 10, 15 or event 20 years of holding the fund. Yet, studies have shown that the average holding period of a mutual fund is only 3-4 years.

• By my own computations, for an investment earning 10% each year, the impact of a 5.75% commission is as follows:
• To "break even" (i.e., the result if no commission were paid), in 5 years (which is, of course, longer than the average holding period of a mutual fund) requires the fund to earn 1.2% better annualized returns;
• To break even in 10 years requires 0.59% better annualized returns;
• To break even in 15 years requires 0.43% better annualized returns;
• To break even in 20 years requires 0.32% better annualized returns. I would note that this is greater than many "robo-advisors" charge for their annual fees, for 20 years worth of investment advisory services.
• Of course, there is no empirical evidence that commission funds, on average, do better than no-load (and no 12b-1) funds, gross of fees. Just because a commission is paid on the sale of the fund does not make it a better fund. Nor does a higher annual expense ratio make it a better fund.

• Of course, most Class A mutual funds, in addition to possessing management and administrative fees, also possess 12b-1 fees - often 0.25% a year.

• And often Class A mutual funds pay significant brokerage commissions (including soft dollar compensation, an insidious practice) to brokerage firms, when transacting securities within the fund - and these brokerage commissions are not included in the annual expense ratio of the fund.

• Wall Street's sell-side business model cannot survive the fiduciary standard. A fiduciary has the legal duty to ensure that any fees and costs expended by the client are reasonable. Wall Street's current business model, built upon high, multi-million dollar compensation to a home office full of executives, often with the goal of extracting 2% in total fees each year from a customer's account, is doomed. As are the business models of most insurance companies. Should fiduciary standards be applied broadly and correctly to the provision of all investment advice, the revenues of the major broker-dealer firms and the insurance industries will plummet. The shake-out will occur.

• Investment banking will become less profitable. If investment bankers have to market their products to true fiduciaries, rather than rely upon product sales forces to hype IPOs, the greater scrutiny will result in far greater evaluation of the merits of IPOs, and more efficient pricing of these offerings in the marketplace. Without the ability to secure high (and often unwarranted) pricing, investment banking fees will decline, and the investment banking industry will become more competitive. The decline of this major source of the revenue for Wall Street's wirehouses further seals their doom.

• Wall Street has no real advantage over independent, fiduciary investment advisers today. In fact, independent investment advisers can access nearly any investment product today. Brokers at a warehouse? Only the (usually high-cost) investments approved for their "platform." And the support given to brokers is often terrible and burdensome - poor software solutions, marketing programs hindered by news of settlement after settlement resulting in customer distrust of the firm and its advisers, and burdensome FINRA-imposed compliance requirements. In contrast, even small, independent firms can access competitively priced software and other solutions.

• [Of course, let's also note the desperate attempts by firms to preserve their market share by restrictive non-compete and non-solicitation agreements, coupled with deferred comp arrangements to further incentivize brokers to stay. But, wiser brokers will realize that they will build more equity, and have greater freedom, and greater income over time, by going independent.]

• Being an independent fiduciary advisor is enjoyable. No fears of liability - because you act as an expert and avoid the many conflicts of interest that get Wall Street's firms (and their representatives) in trouble. Much deeper relationships with clients. Going to work is not about selling, or meeting a sales quota, or meeting a level of sales which triggers higher payouts. When you work as a representative of the client, acting as a trusted advisor, and you are paid directly by the client (and not dependent upon whether a transaction is undertaken), you are free from sales pressure from your manager, and any pressure you might put on yourself. You also have the stature of being a true professional, not a product salesperson. It's a great way to spend a day.

The DOL's "Conflict of Interest Rule," if finalized, will accelerate the move away from the Wall Street and insurance company dinosaurs (for which the extinction event is looming) to a new era of professional financial and investment advice. I'm not saying that the DOL's proposal is perfect; rather, it is a significant step toward a true fiduciary culture in financial services. (And, to move further, the proposed BICE exemption should be viewed as a temporary concession permitting firms to adjust, and should be sunset after several years.)

Fiduciaries Will Prevail in the Marketplace. Even if the DOL's rule is thwarted by Congressional intervention (which is possible, given the huge sums of money and hordes of Wall Street and insurance company lobbyists descending on Congress), independent advisers will continue to gain market share, and Wall Street will continue to lose market share. Simply put - Wall Street's sell-side business model is not desired - by consumers, or by new advisers entering the industry. It will take longer to move toward a profession, and perhaps another financial crises will need to occur before Congress has the gumption to "get tough" on Wall Street. But it will occur.

Imagine the financial planning and investment advisory industry some 20 to 50 years into the future. What you see is a host of professional services firms - some quite large, some mid-sized, and some small (with many solo practitioners).

• These professionals advisers all act as fiduciaries to their clients, in adherence with strict, non-waivable fiduciary duties of due care, loyalty, and utmost good faith.

• Firms possess clear career paths for associates to move from supporting advisers to lead advisers (junior partners) and then to senior partners. Senior partners are highly compensated, partially due to their high expertise, but partially because they have associates working for them and derive profits from their activities.

• Technology is heavily employed to streamline investment operations and to deliver world-class client experiences. But, at many firms, the strength of the relationship between adviser and client is even stronger than it is today.

• A much higher degree of due diligence is undertaken on investment products. Risks are identified. High-risk, low-return products have little chance. The asset management industry provides much lower-cost investment products than are seen, on average, today.

• The compliance burdens on firms are eased. Gone are regulations requiring annual risk audits and a huge compilation of records for periodic inspects. In their place is instituted a principles-based Professional Standards of Conduct, stressing the need to avoid conflicts of interest wherever possible.

• Professional regulatory organizations exist to safeguard the public. Gone are the frequent, intrusive periodic inspections of firms - except that inspections for asset verification (custody) are more frequent (to deter actual fraud). Limited government resources are focused to combat severe problems. Peer review of complaints, and of administrative law decisions, occurs. In short, financial and investment advisers are regulated as professionals.

The timeline for Wall Street's demise, and the emergence of a true profession, is uncertain. But it will occur. It is what consumers want. It is what individual advisers want. It is what the nation, and the U.S. economy, needs.