The Business of Investing - Part 2/6: Brokers, Advisors, and Middlemen

The Middlemen

The practice of paying someone a fee for investment advice is fairly recent.  The Investment Advisors Act of of 1940 governs the dispensation of advice, but the practice itself remained a sideshow until roughly the late 1970s.  The reason was that the far larger, better established business model wasn't to provide advice but to broker securities transactions.

As the American economy grew and became increasingly industrialized, securities markets developed as a source of capital.  Banks continued to lend debt capital, but the need was greater than the availability of loans, so companies issued bonds.  If you think about it, a bond is very similar to a bank loan: both are promises to payback the borrowed amount, plus interest.  They differ mainly in the source of funding (bank lending portfolios, or investors).

Some companies didn't want - or couldn't afford - the interest payments associated with bonds and bank loans.  Their business models might take more time to develop, and cash might not be flowing so soon after starting.  However, the entrepreneurs launching those businesses were willing to give up a portion of the ownership of the company in exchange for capital needed to build factories, purchase machines, and pay laborers.  The solution was common stock, or equity capital.

With a growing population and the only intact manufacturing capacity among major countries, the US was uniquely positioned for growth following World War II.  Capital was needed to fund the expansion, and capital markets matured to meet the need.

Investment banking served a similar function to traditional commercial banking: both provided capital to fund the massive US economic expansion.  Commercial banks made - and usually kept - loans.  Investment banks, on the other hand, underwrote - and usually sold - new stock and bond issues.  Those new issues were sold primarily to wealthy customers of investment banks, many of whom were industrialists themselves and thus qualified to weigh the risks of owning the new securities.

The stockbroker arose as the intermediary between the underwriters at the investment bank and the rich customers who could purchase the new bonds and stocks.  A broker's function was never be the objective purveyor of sound advice, but to place securities.  Their compensation was structured accordingly: with new issues they would collect part of the spread between the price a security was offered to the public and what was passed on to the issuing company.  But brokers also participated in the secondary markets for securities - the exchanges - and would collect a commission for helping customers sell one stock to buy another.  The function of the broker and his compensation structure were fairly unobjectionable.  Sure, a rogue broker could lie to his customer, but the basic function of placing securities and charging commissions worked well, given the broker's obvious purpose and the his customers' average sophistication.

The Emergence of Advisors 

In the mid-late 1970s the business of investing began to change dramatically.  On May 1, 1975, the Securities and Exchange Commission abolished the fixed commission schedule.  Previously, the only real difference between a broker at Bear Stearns and one at Merrill Lynch had been which one had the best access to new offerings.  In mid 1975 though, guys like Charles Schwab and Ernest Olde took advantage of the new de-regulation to begin offering deeply discounted commission rates.  This action had two effects.  First, the demise of the previously high, uniform commission schedule meant that average savers, or "retail investors," were no longer effectively priced out of owning stocks.  The second effect was that traditional investment banks, which had elected to retain high commission rates, were suddenly forced to justify their costs; in part they did this through research.  Analysts at "full service" firms issued research reports with the purpose of providing opinions on which stocks investors should buy.  Brokers likewise began to assume the role of advisor, offering to help customers choose among different investments.  Of course they still retained the function of placing underwritten securities, but they began to see themselves as more than simply brokers for new and secondary issues.

In 1978, Congress amended the Internal Revenue Code and created 401(k) accounts, so named for their section in the Code.  Initially, this new arrangement was targeted to high-income employees as a means of deferring tax on a portion of income.  But businesses soon found this vehicle to be an attractive offering for employees.  Why?  401(k)s allowed employees to bear some of the risk of saving for their own retirement, rather than the company assuming that risk via traditional pension plans.  In the highly taxed, economically moribund milieu of the 1970s, shifting risk and cost to employees was very attractive.  The mobility of the US workforce would also soon limit the value of the pension.

Pensions, like health insurance, were always a benefit of employment - they were  never a right.  But as is often the case, a benefit long enjoyed may come to be viewed as a right.  However, the key point to understand is that pensions never shielded employees from risks: their employers just absorbed the most obvious risks for them.  Pensions worked not as a transfer payment system (a la Social Security), but as common funds.  More plainly: corporations could fail and the ultimate successes of the pension plans with them.

Mutual funds - also around since the end of the first half of the 20th century - exploded in popularity as the investment product of choice in 401(k)s.  Originally designed as means for retail investors to band together to purchase professional securities management, mutual funds were rightly seen as practical investment vehicles in accounts with relatively small balances.  The new 401(k) demand launched myriad mutual fund companies and led other, well-established fund "families" to expand their offerings rapidly.

Not to miss the new trend, brokers got into the 401(k) business too, offering plans to employers of all sizes.  The value a broker brought to a firm offering a 401(k) plan was decidedly more advisory in nature: he wasn't placing securities, he was helping employers educate employees on how to save for retirement.  

Fee Only


As brokers became - and were sought out as - advisors, some of them started to think critically about whether their compensation structures aligned their interests with those of their customers.  Whether compensated via stock commissions or mutual fund "loads", these advisors were sensitive about the awkward relationship between providing objective investment advice and being compensated by fund companies via commissions.  The "fee-only" model emerged in the early 1980s as a counter to the commission model.  Fees compensated advisors apart from the transaction, and so meant a better alignment between the advisor's goals and those of his customers.

Brokers could sell loaded funds to customers, but these new fee-only advisors eschewed commissions.  "No-load" fund companies grew, in part, to satisfy this niche.  Of course, fee-only advisors needed to be paid, so they began to charge fees on top of the mutual funds they recommended.

At the same time, an in concert with their convictions about compensation, many fee-only advisors began to embrace the notion of fiduciary responsibility.  A fiduciary is a service provider who puts his customers' interests ahead of his own.  Brokers, by contrast, retained the "suitability" standard: a broker is obligated to recommend products that are suitable for customers, but he is not required to actually subordinate his own financial interests to those of his customers.

Still Brokers, Still Middlemen

Through this time of intense change, two main aspect of the retail investment business remained constant.

First, brokerage firms never fully bought into the idea that their sales people were actually advisors.  Brokers, they continue to think, are there to place securities, not to guide their customers.  And so, commissions continue as the predominant compensation method among brokerage firms.  Today, though, instead of paying brokers place stocks and bonds - a function that has been in declining demand as our economy has matured - brokerage companies pay brokers to place "financial products" like mutual funds, exchange-traded funds (ETFs), and annuities.  For every loaded mutual fund sold to a brokerage customer, the fund company pays a commission (the "load")  the brokerage firm, which in turn shares a portion of that commission with the broker.  Likewise, a portion of the annual fee - known as a "12b-1" - is also paid to the brokerage (and broker) as a means of ensuring that brokers continue to recommend that their customers keep their mutual funds.

"That's fine," you might say, "but aren't some brokers honest despite their compensation incentives?"  Sure, it's possible.  But having spent some time near the beginning of my career as a broker, I have to tell you that the basic broker motivation is absolutely to sell a product with a high recurring commission - the 12b-1 - and collect the stream of payments while doing as little work as possible.

Yes, it really is that gross. 

Secondly, both brokers and fee-only advisors grew out of - and remain in - the middleman model.  Regardless of compensation practices, advisors are, for the most part, not trained as analysts.  They don't value securities themselves, they outsource the investing function to managers of financial products.  The vast majority of advisors are not only unprepared to utilize individual securities, often times they display a naive fear of them.

Across industries, unless the middleman function is truly an efficiency creator, it will add a layer of cost to the end service.  And of course, costs have to be justified at some point.  One way costs are justified is through offering ancillary services like tax preparation, insurance sales, or financial planning.  Another way costs are justified is through complexity.

If a service is actually complex, it might merit a higher fee.  And certainly, there's nothing wrong with offering ancillary services. But is it possible that the practice of investing in mutual funds isn't actually all that complex, and that the apparent complexity has been arranged as a pretense to justify higher fees?  Remember: mutual funds were created for small investors to band together to achieve scale and hire professional management.  Mutual funds are, in and of themselves, diversified instruments.  Furthermore, are ancillary services merely offered alongside primary investment management offering, or are they in effect the means advisors use to attract new business?  
 

Where We Stand Now

I operate in an industry where the vast majority of my competitors either A) are compensated for placing products, not for rendering good investment advice, or B) are not actually investors themselves, but cost-adding middlemen.  Is there really any wonder that the average investor is under-served and over-feed?

With this post as background, the next few posts in this series will highlight some of the key ways - methods that are not just commonplace but predominant - in which either compensation or competency dilute the potential effectiveness of investment advice.

  

The Business of Investing - Part 1/6: Introduction

For all my griping about blind advocacy, I do advocate from time to time. I believe strongly in minimizing coercion and will tell you about it if you give me half a chance.  I’m passionate about free enterprise and for me, it’s not the “enterprise” part that’s rewarding as much as it is the “free” part.  The individual and societal benefits of freedom accrue most broadly and rapidly when counter-parties are informed and agree to an exchange, without threat of force.  The consumption of investment advisory services is one area where there is a basic lack of necessary information.  In other words, one of the parties isn't well informed.  So, I am certainly an investor education advocate.

I continually find that investors don’t know how to evaluate – i.e. “shop for” – investment management services.  The result is that the purveyors of investment advice tend to be an oddly diverse bunch, occupying spots all along the competency scale.  It’s a peculiar phenomenon, really.  Take the field of medicine as a comparison: there are certainly differences between doctors, but if two docs have MDs and are both board certified in the same field, patients can rest assured that they are buying a basic level of capability and that each doctor is likely to care reasonably well for them.  Law and public accounting are similarly narrow with respect to competency.  And at the other end of the services spectrum, you also tend to find a relatively narrow band of competency among, say, lawn mowing service providers, and for obvious reasons.  But with investment advisors, you’ll find individual investors working with everybody from math & finance PhDs in New York to annuity salesmen in Paducah.  

The spectrum itself is a curiosity, but what agitates me is that such a large percentage of investment advisors cluster in a relatively tight range we might call "not-really-competent."  Why do investors keep paying – and often times paying way too much – for this level of non-competency? 

Pause.  I’m being careful to speak about competency of practice.  I’m not suggesting a basic lack of intellectual capability.  Of currently working advisors, a far larger percentage of them could be practicing competently than is currently the case.  It’s not a lack of smarts; but what is it?

      

The answer to that has a lot to do with the evolution of the investment business.  Many advisors lack competence because it’s not demanded of them.  Their employers do not encourage them to be competent because it doesn’t fit the business model.  It’s a matter of institutionalized incompetence, actually.  But it doesn’t have to be this way.  There are alternatives.  One alternative is to give Federal agencies more power to control financial advice.  You can imagine that in my reluctance to coerce, I’m not wild about either the hit to freedom or the level of effectiveness that this choice would yield.  But, as a friend recently challenged me: if education - instead of regulation - is the best option, then what exactly am I proposing?

Touché. 

   

I'm not sure how much I can do by myself, frankly, but it's worth trying.  I believe I can help investors become better informed, free participants in the selection of investment advisory services, and if I'm right, I might be able to do some good - at least among the small number of people within my sphere of influence.

This is the first in a series of posts explaining how we got to this point, a point where far too much money is paid for far too little quality.  I also want to propose the "what" and "why" investors can do about it.  In the post following this one, I’m going to talk about the history of investment advice – high level – to point out how we’ve come to the place we are.  In the posts that follow, I’m going to call out specific practices that are most limiting to the attainment of good investment advice.  Then I’ll conclude with some suggestions of what a healthy and ideal investment advisory relationship looks like.  

I’d love to have your feedback on this series.  Portions of the material is totally self-congratulatory: the ideal practice I describe looks a lot like my own.  I could choose to be shy about that, but instead I’ll just note that I’ve spent a ridiculous amount of time over my career becoming competent individually and searching for truly competent partners with whom I can hang out a shingle.  I'm comfortable with the awareness that having made many earlier mistakes, I do now 'get it.'  Look, I  don't think my firm is the perfect investment management solution; I just want to share what I know.

But let’s face it: I’m a career investment guy.  I can no longer see easily how non-professionals perceive the investment advisory business, and I'd love to have your feedback on whether my opinions translate into your experience.

Carr on "The Retirement Gamble" Documentary - Retirement Weekly (MarketWatch)

If you're concerned about investment industry practices and how they impact individuals and their retirement savings, you absolutely should watch Martin Smith's Frontline documentary The Retirement Gamble.  Here's a link to the film.   It's 52 minutes long and worth your while.  I don't agree with everything said or implied, but on the balance it's important and straight. 

Bob Powell of the Wall Street Journal's MarketWatch asked me to comment on the film for his Retirement Weekly column.  My comments are below.

Stephen Carr, CFA, Director of Research, Peloton Wealth Strategists:

"Martin Smith’s Frontline documentary “The Retirement Gamble,” had me jumping up and down with enthusiasm.  Yes, there were a few points where I cringed, but for the most part, Smith gets it right: compensation practices in the investment advisory business are really, really gross.  There’s so much that’s wrong; where to begin?

Fee opacity is a good place to start.  Think about this: what percentage of annuity investors would ever buy one if they truly understood that their total annual expense ratio was north of 2% or 3% and that, if they need to access their money before the 7, 10, or 20 year surrender period had ended, they’d need to pay an exorbitant penalty?  The same can be asked of mutual fund 12b-1 fees. 

Compensation structure is also a key point raised in the film and, unfortunately, most financial advisors are compensated for selling so-called “financial products.”   Financial products are co-mingled vehicles like mutual funds, annuities, and unit trusts.  Virtually the entire advisory business is designed not to tailor investment solutions to the needs of individuals, but to distribute these products.  Armies of financial advisors are incentivized as “asset gatherers” or “relationship managers.”  They’re not really expected (and certainly aren’t compensated) to be great investors of their clients’ money.  Frankly, if a financial advisor is at all knowledgeable as an investor, it’s purely coincidental.       

Whether, as the film suggests, more regulation is called for is debatable.  The only certain way bad practices get corrected is by investors demanding improvement.  Investors can make three demands that will go a long way toward righting this ship.  

First, investors need to understand that contrary to Peter Lynch’s claim in the film, investing well is actually difficult.  When choosing an advisor, investors should, when possible, hire a money manager who utilizes individual securities, not financial products.  Individual securities carry no fees, so the total cost is limited to the management fee and some commissions (which are frequently very cheap these days).  Increasingly 401(k) plans offer employees the option to “self-direct,” which would allow a third party money manager to invest on behalf of the individual. 

Secondly, investors should limit how much they’re willing to pay for management.  Jack Bogle gets it right: investors should keep total costs to 1% or less.  While Bogle seems to falsely equate indexing with low-cost investing, the two are not identical.  There are numerous reasons why an individual might not want to assume the risk associated with particular index funds, but that doesn’t mean that the only other alternative is high-cost, poor performance.    

Finally, the fiduciary standard is critical.  Two well-regarded designations that require advisors to uphold a fiduciary standard are the Chartered Financial Analyst (CFA) and the Certified Financial Planner (CFP).  Professionals holding these designations have attained a certain level of industry experience and are required to put their clients’ best interests ahead of their own compensation.

My hope is that one day, investment advisors will be held in the same high regard as other professional service providers.  But while some advisors have earned that honor, many others continue to pollute the industry with selfish ambition.  Until investors begin demanding more honorable compensation practices from their advisors, there will be very little incentive for change."