Saturday, September 19, 2015

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.


  1. Hi Ron:
    Great article. You have described why Wall Street cannot afford to let this happen. But, the pressures will continue to build over time. Hopefully, we do not need another 2008 for politicians and regulatory agencies to see the light.

  2. Hi Ron,
    I recommend that you do a little more research into annuities. Even Harold Evensky is now stating that annuities can play a major role in planning. The problem with the RIA community is the persistent error of evaluating annuities as investments. They are insurance and need to be evaluated and used as insurance. Their expenses make them a poor choice as an investment. Their guarantees make them essential in many portfolios as insurance.

  3. EDH,
    Thanks for the comment.
    I research annuities extensively. I have taught college classes on insurance and investments, and continue to do so. I evaluate annuities as both investments and insurance, as I believe many RIAs do.
    There are many types of annuities, of course. Some have uses, others fail the cost-benefit analysis, and as to at least one kind of annuity I'm still on the fence. Here are my current views:
    1) Immediate fixed lifetime annuities are underutilized. Hopefully long-term interest rates will rise someday, leading to better annuitization rates for immediate lifetime annuities, leading in turn to their increased utilization, especially with either CPI riders and/or undertaken via a laddering approach over time.
    2) No-load, low-cost variable annuities can play a role in some clients' portfolios. Vanguard, Fidelity, Jefferson National, and others have good low-cost VA products, as do some others.
    3) High-cost variable annuities, with GMWB or similar benefits, often cost 3.5% to 4% a year in total fees and costs, and upon annuitization usually have very uncompetitive annuitization rates. They have yet to survive my cost-benefit analysis. The protection of a "high water mark" is largely illusory, over long periods of time, when the fees and costs (along with mandated allocations under many GMWB riders) so drag down the returns that good high water marks can't be attained. Fees and costs matter - the academic research on this is compelling, if not conclusive. Also, under many contracts, timing of entry and annuitization must be just right to reap the maximum benefits, such as they are.
    4) EIAs aka FIAs are interesting products, conceptually. I wish there were more products out there, without sales loads, from companies with superior financial strength. Also, superior returns to those found in EIAs can be done through the purchase of LEAP options combined with fixed income investments, when done by an experienced and knowledgeable advisor. My due diligence has not yet revealed to me a specific EIA I would recommend to a client, but I remain open to looking at new EIA products as they appear.
    5) I have not yet reached a conclusion about longevity annuities. While I acknowledge their potential benefits, intellectually I think their use in the context of overall portfolio/resource allocation is the reverse of what should occur. I.e., should annuitization occur for a fixed term, such as 20 years, followed by use of the balance of the client's portfolio (presumably invested more heavily in a diversified basket of equities). Yet, fixed annuities don't offer kickers from mortality experience. It's an area which I continue to study, and read about and think about. I think our research on meeting retirement income needs is still in its infancy.
    Hope this responds appropriately to your post. Thank you again. Ron

  4. Terry R Altman CLU CFP(r)September 24, 2015 at 10:41 AM

    I appreciate your balanced comments regarding annuities and that you avoid the extreme position on either side. My concern with your comments on "commission-based compensation" relates to other insurance products--life insurance, disability insurance and long-term care, most prominently. My over-arching concern is that in the drive to eliminate commissions that many planning firms utterly neglect risk management, one of the key elements of financial planning. While a focus on investments alone can lead one to the wish to abolish commissions, the insurance marketplace (while improving marginally) has not yet developed for risk products other than (arguably) annuities. While a stellar investment firm is a wonderful thing and will be helpful in the extreme to many clients, to disregard risk management is to disavow "financial planning" as it was originally conceived.

  5. Terry,

    Thanks for the comment. The DOL rule is focused on investments, and I believe the major impact of the rule will be on the fortunes of broker-dealer firms and high-fee asset management companies. To the extent insurance companies sell high-cost VAs and EIAs, they will be impacted significantly as well. Even greater impact will be felt in the non-publicly traded REIT area, if the DOL continues with its proposal which would prohibit their use by those under the BIC exemption.

    I concur that other aspects of financial planning (budgeting, saving, smart expenditures, tax planning) and risk management (through risk avoidance/minimization and/or insurance) are important. In fact, I'm of the view that financial planning should be undertaken, to a large degree, prior to investing funds. The presence of certain risks may well affect the design of the investment portfolio. And there can be a better use of funds (for example, to buy insurance protections) in some instances, rather than just investing it all.

    The term life insurance market is fairly competitive. As are the auto and homeowner's insurance markets. We see a lot of "direct sales to consumers" in these areas (benefitted, no doubt, by web-based platforms). Disintermediation, whether it be in the retail industry (think Amazon) or in insurance (Geico, Progressive, many more) or in investments (think robo-advisors, Vanguard, Fidelity, discount brokers), can be a powerful thing.

    In the other insurance markets, there has been less penetration by direct-to-consumer sales, or with lower-cost products. In part this is because of the complexity of the products. In part it is because the universe of those needing the product and able to purchase it (think disability insurance) is smaller than the universe of other products (think auto insurance). In part it is because there are state laws which prohibit, in many states, rebating of commissions (life insurance, and in some states annuities). Still, as the number of fiduciary advisors, acting as purchaser's representatives (and financial planners) increases, marketing of lower-cost products to these advisors will occur. Insurance companies won't ignore the competitive advantage they will gain by being first-to-the-market with "no-load" (or "load-waived") products in these areas. It will occur. It will just take longer.

  6. If I were starting out, as a young financial advisor today, I would not seek to build my business around commissions. There are just too many marketplace forces (and a few regulatory ones, possibly) which will challenge the commission-based model. And I wouldn't build my business around 12b-1 fees, either (I've previously blogged about this.) While I might engage in commission-based sales, where good alternatives don't exist (as you've stated, in some insurance markets currently), I would instead emphasis my role as a consultant - i.e., having the ability to analyze all of a client's financial needs. I would likely charge as a consultant (hourly basis, or fixed fee for projects, or a retainer), when possible.

    These are challenging times. A good bit of disintermediation is occurring in many types of commercial businesses. New business methods are emerging, often with the aid of technology, offering a greater value proposition (at least for some clients). Some reintermediation (such as fiduciary advice) also is occurring. These changes have been going on for some time. I believe these changes will be accelerated should the DOL's rules be finalized and put into effect.

    Fortunately, the transition won't be as severe as that forced by the U.K., when it enacted a ban of many (but not all) commissions in the investment and insurance areas.

    Still, this trend toward professional-level compensation, and client-directly-paid fees, is a powerful one. Whether or not accelerated by regulators, the marketplace is speaking. I doubt the trend toward client-paid consulting fees (hourly, retainer, project, AUM) will stop, and I sense it is accelerating. The winners, over the long term, will be firms and advisors that adapt to these trends, implementing a business strategy which provides them with an edge in the marketplace. This means re-visiting the value proposition, and perhaps re-defining it.

    It also means, I would hope, top-driven-down embrace of a fiduciary culture, and transforming away from a sales culture. That's a very difficult transition. But, for those who undertake the transition, it can be a very rewarding one.

    Thanks again. Ron

  7. This is a very good assessment of the realities facing brokers that are attempting to serve as advisors. There is a very real conflict. Thank you for a clear analysis of the landscape, and a good view of what's needed in our industry moving forward.
    I am surprised there's no mention of CEFEX - the Center for Fiduciary Excellence, which provides outside certification that a firm is actually functioning as a fiduciary. As a CEFEX firm we've been able to benefit from embracing the fiduciary standard, and putting our clients first every time.
    This ties directly into the analysis of annuities. When an Advisor establishes a proper working relationship with clients, backed by an academically driven investment approach, the only need for a product to back them up is if the client is unable to control the spending, or is unwilling to listen to the advisor's counsel. I often point out to clients that "the only way anyone can guarantee anything financially is if the company puts restrictions on your behavior."


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