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.
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