Dirty Rotten Scoundrels, Part II: The Wall Street Multi-Level Marketing Machine.

May 21, 2013

If you read last week's missive, you will recall that our protagonists, Wall Street's brokerage Overlords, had discovered the magical elixir of assets under management (AUM) and fee-based compensation.
This week, we will consider how the Financial Services Fiefdoms hatched a plot to combine AUM and fee-based compensation with the allure of Buy-and-Hold Investments.
The plot, beautiful in its simplicity, resumes now...
. . .
Long ago, in the era of pinstripes, pagers and Pall Mall, the Overlords of Wall Street's cash-flooded canyons fell in love.
The object of their affections? The big, easy money being made by "low-brow" companies like Wal-Mart and McDonald's.
Wall Street loved the idea that McDonald's need not offer sophisticated menus in order to maximize profits. McDonald's focused on quantity, not quality.
So, Wall Street followed suit. And established its own equivalent of the fast-food drive through.
Yet, the Overlords knew that Main Street would not willingly buy financial hamburger. The idea needed to be cloaked within a "Happy Meal" of sophistication.
Wall Street realized that Americans believe most of what appears on TV. So, the Overlords developed multi-million dollar advertising campaigns. These majestic 30-second stage plays touted complexity, sophistication and peace of mind. Aired during major sporting events, Main Street's Ad-prone imaginations ate them up.
Total Merrill... You & US, UBS... Smith Barney: When they speak, people listen...
And listen, Main Street did.
Wall Street's Overlords sent their lowly minions across the land. These broker/salesmen (BSers) would pose as advisors. They would mindlessly gather new assets for the Wall Street Overlords. Assets wooed from the trusting hands of Main Street. Through cold calls. Steak-laden, booze soaked seminars. 18 holes on a weekday.
Once assets arrived, the BSers would not manage the assets, per se. Too time intensive. Instead, they would outsource client nest eggs to third-party programs. Mutual funds. Separately managed accounts. Money managers. Hedge funds.
"These are the best money managers in the world," they lectured. "Unearthed, like Babylonian archaeological treasures, by our world-class due-diligence department in New York."
What a sham. An immensely profitable, self-serving sham.
Because the less portfolio management required, the more the BSers could sell. And if the BSers could ignore portfolio management and other sophisticated financial exercises, then the firms could actually hire, well, salesmen.
Consequently, half the BSers hired came from disparate professional backgrounds. Real estate agents. Account executives. Car salesmen. Stay at home moms. Each given a chance to deliver AUM into the firm's main vain.
Can't sell? You're fired. Then, the remaining BSers would fight like rabid pack animals to keeps the remaining accounts. Raw meat, tossed like motivational scraps, so the surviving BSers might develop a taste for it.
. . . .
Question: What's the difference between your investments, and those utilized by your broker?
Answer: He actually manages his own investments.
. . . .
Charles Hugh-Smith of TwoMinds blog points to recent research that underscores the audacity of Wall Street's "Rentier Rip-Off." A culture that skims fees from Main Street via mediocre investment vehicles, enabling Wall Street to get rich from the annuitized income.
Recent research on The Motley Fool analyzed ten thousand mutual funds. The research revealed that only ten of the ten thousand actively managed mutual funds managed to beat the S&P 500 consistently over the course of the past ten years.
Average performance? All the worse by the above-average fees.
A quick glance at Yahoo Finance reveals the average expense ratio for growth and income style mutual funds is 1.29%. As a result, approximately $1,883 of every $10,000 invested over the course of ten years will go to the fund company in the form of expenses. Compare that to the Vanguard 500 fund, designed to mirror the S&P 500 index, which boasts an annual expense ratio of 0.12%, resulting in ten-year compounded expense of $154 for every $10,000 invested.
Yet, the index beats nearly all actively managed funds. In fact, TwoMinds shows a complete lack of performance by most funds.
Results of some recent performance screens were sobering. TwoMinds looked at 24,711 funds on Yahoo Finance's fund screener. Using basic criteria, the screen revealed a mere five fund managers who beat the S&P 500 index over five years.
Next, TwoMinds analyzed 17,785 funds on The Wall Street Journal's online screening tool. Using slightly different criteria, the screen found 71 mutual funds out of 17,785 that outperformed the index over ten years.
Translation: the index beat 99.6% of all mutual fund managers. Out of 10,000 mutual funds, roughly 40 managed to beat the index. Before fees.
Separately managed accounts? Money managers? Hedge funds? No better.
Wall Street's Fast-Food Drive Through could be, perhaps, the greatest easy money, multi-level marketing scheme ever created.
The top four largest brokerage firms have over 40,000 "financial advisors" between them. Those advisors, each and every week, are hunting for new asset under management (AUM). Once captured, the AUM is assessed an ongoing "advisory" fee for the financial advice being rendered. Say, around 1.25%.
Next, those advisors outsource (!) control of the new assets to mutual fund managers who also charge a fee. Say, 1.23%.
"Finally," you think, "Someone who will actively manage the portfolio, using their best ideas in an attempt to outperform the benchmark indices."
Today, most mutual fund managers peg roughly 70% of their portfolio to the benchmark index. Then, they actively manage 30% of the portfolio, hoping to add a bit of Alpha, or outperformance. Unfortunately, the great majority of them do not.
In 2011, the Investment Company Institute reported that $23.8 trillion was invested in mutual funds.
Let's assume there are 10,000 reputable funds to choose from. So, in 2011, if the average fund charged a fee of 1% (it was actually more) there was enough to provide each of those 10,000 funds with fees of $23,800,000.
Like the brokerage firms, the mutual funds realized that there is so much money to be made that the object is to simply stay in the game. No reason to take risks. The mutual funds, like the brokerage firms (sometimes one in the same), realized that it all comes down to one simple idea: Assets Under Management (AUM). With enough AUM, you need not develop the best mousetrap. You need only develop a mousetrap capable of maximizing the number of mice.
As of December 2012, some of the most widely held, reputable mutual funds had underperformed their benchmarks the last five years. Growth Fund of America. Fidelity Contrafund. Dodge & Cox Stock. Fidelity Diversified International.
The average large-cap index would have performed better.
Still, Wall Street's vast multi-level marketing machine manages to attract billions of dollars a year. From the very Main Street taxpayers who bailed these firms out in 2008.
Because your advisor is taking fees from your portfolio every year. Say 1.25%. The mutual funds to which he outsourced your portfolio are also taking another 1.23% in fees ever year - not to mention the annual taxes, trading and redemption fees. So, the investor is already down 2.48% before the first statement arrives.
Following, the mutual fund manager mirrors two-thirds of his AUM to the benchmark. Why? Because the fund industry realizes that it's better to play it safe. And, since none of the funds, statistically, outperform anyways, why try?
Finally, the real kick in the groin. All of the above is packaged in the world's most self-serving methodology: Buy and hold. More aptly called, buy and hope. Because you buy the funds, hold them through thick and thin, and hope the market makes your advisor look good.
The Buy-and-Hope Mentality (BAHM) colluded on by the brokerage firm and mutual funds industries (remember, sometimes they're one in the same!), offers no downside protection. Even in the worst of markets. The kind we've experienced twice in the last 13 years.
Using an actively managed portfolio filled with ETFs and individual investment positions, an investor can establish a trailing stop beneath the market price of his investments. This enables the investor to exit any position at a pre-determined price, should markets become volatile.
Yet, mutual funds, SMAs, money managers, and all of Wall Street's other BAHM vehicles do not permit the utilization of sell stops or other downside protection mechanisms. In fact, most of the BAHM investments are permitted to hold no more than two to four percent in cash. They are contractually obligated to remain fully invested.
. . . .
Question: What a conflict of interest?
Answer: Wall Street's earnings per share obsession colliding quarterly with Main Street's nest eggs.
. . . .
What has Wall Street learned since 2008? Nothing.
Only last week, a lunch date explained to me that his friend, an advisor with Merrill Lynch, was explaining how he was, in fact, "A little bored..." Because his book of business, "Pretty much runs itself."
I'll wager that his own investments are being regularly scrutinized. But, I applaud his honesty.
In the fall of 2007, U.S. retirement funds equaled roughly $17.9 trillion. At the end of 2011, retirement funds across the nation held roughly $17.9 trillion. Four years. No change.
During that same period, Wall Street received tax payer bail outs. Firms and salesman/brokers continued to collect fees on AUM. Many brokers went to different firms and collected huge bonuses. As firms were acquired, many brokers were paid retention bonuses for nothing more than staying.
Most of those brokers continue to outsource to mutual funds and SMAs. Which continued to underperform. And collect fees.
The advertising campaigns seen during The Masters, NCAA Tournament and Super Bowl may improve, but the products and services never do. Clients get a round of golf here, a steak dinner there. But Wall Street's objective is maximizing profit, and rewarding insiders. On the backs of outsiders.
Outsiders? Thy name is Main Street.

Securities offered through Dempsey Lord Smith LLC – Dempsey Lord Smith LLC, Rome, GA Member FINRA / SIPC / MSRB.

Advisory Services offered through Dempsey Lord Smith, LLC, an SEC Registered Investment Advisor. Clearing through and accounts held at Charles Schwab & Co., Inc.

Dempsey Lord Smith, LLC nor Hyde Park Wealth Advisors LLC provides tax or legal advice and you should consult your accountant and/or attorney if considering an investment of this type. Hyde Park Wealth Advisors LLC is not controlled by or a subsidiary of Dempsey Lord Smith LLC. Investing in Alternative Investments come with a variety of risks that could result in a complete loss of principal investment.

Alternative Investments offered as private placement securities are offered only to qualified accredited investors via confidential private placement memorandum. Income and returns are not guaranteed and there are no assurances investments will meet their stated objectives.

© 2024 Hyde Park Wealth Advisors. All Rights Reserved