Wall Street for Wall Street`s Sake

February 4, 2013

Dating back to the age of J.P. Morgan - the man, not the firm - the world of high finance was entirely wholesale. Wall Street catered exclusively to large corporations, governments and the ultra wealthy.
At the turn of the 20th century, Wall Street realized that it could peddle wares to Main Street. Firms like Merrill Lynch began selling stocks and bonds to families in Connecticut, Kentucky and Kansas.
Along the way, commercialism trumped client interests.
Wall Street has long sold Main Street on the idea that, regardless of the occasional ups and downs, the major indices will go higher more than they will not. Main Street bought in. And so Wall Street did what every enterprising capitalist would - it developed products that fed into the narrative (going higher and higher) while paying the product developers (Wall Street) handsomely.
The 1920s saw the advent of the mutual fund, and over the rest of the century, Wall Street brokers sold these products as if their lives depended on it. The Street eventually developed separately managed accounts (SMAs, essentially mutual funds for affluent households), or money managers, as they're sometimes called.
These products were meant to draw investors into the markets, promising a modicum of professional management and diversification. Yet, while ensuring that Wall Street's fees are residual, the benefits to Main Street are anything but.
Neither of the vehicles offer much if any downside protection. Neither happens to regularly outperform their benchmark indices. Both are expensive.
Still, Wall Street sold a narrative, and Main Street bought in.
Over time, Wall Street saw the true potential this model offered (The Street, not its clients). And so the brokerage firms went from a small cadre of well-informed agents who knew their clients and knew the markets, to armies of semi-informed salesmen. In fact, today's four largest brokerage firms employ over 60,000 salesmen, err - advisors.
Today's brokerages employ the same model used a century ago. Only, the brokers don't know the markets, companies or risks nearly as well as they once did.
Why? Two primary reasons.
First, many of today's advisors hail from advertising, residential real estate, or some other unrelated industry prior to becoming financial advisors.
Second, Wall Street, realizing that most of their advisors are not financial engineers, has created an array of products meant to keep Main Street invested, in good and bad markets, and so keep the fee-based revenues flowing during all market environments. The firms eschew active management, preferring the buy-and-hold method.
Last week, I interviewed a Merrill Lynch advisor. Let's call him Ted. Ted makes less than $0.34 of every dollar earned from his clients. The other $0.64 cents goes to the firm. Ted is fed up with the idea that he has to spend most of his time attracting new clients as opposed to spending time on the ones he has. But, with the firm doing everything it can to elevate profits, its margins are the top priority. So, like any other salesman, Ted is trained and incentivized to find new clients in order to increase his assets under management (AUM).
Further, the firm established that, while Ted can continue to work with clients having less than $250,000, he will not get paid on them. Hardly a productive means of motivating Ted to do better by such clients.
Continuing, Ted has been trained and compensated to primarily place his client's assets within mutual funds or SMAs (money managers). Both of these products adhere to the age-old maxim that the market, while going up and down, will go up over the long run. The problem is, that long run may not always arrive before retirement.
There are innumerable investors whose portfolios remain below their 2007 highs because they utilized such products. These products offer little-to-no downside protection, carry hefty expenses, and require little of the investment advisor beyond the occasional client call, a quick market opinion, and a return to trolling for additional clients. Because the firm has squeezed margins to the point that the only way to make a living is to have a ton of clients.
Need anecdotal evidence?
While I was with Smith Barney, there were advisors in Cincinnati who had over 1,000 clients. Many advisors had over 500 clients. All of these clients owned mutual funds or money managers (usually the same ones funds). And aside from buying the occasional annuity, or printing a colored chart or analysis, the personalized financial services ended with printing a home address on monthly statements.
Wall Street, meet McDonald's. The drive-through is open.
Lets derive some insight from Nassim Nicholas Taleb, former quantitative trader, NYU professor, and author of such classics as The Black Swan.
Taleb often discusses the idea that nearly all systems, like markets, love uncertainty and improbability. So, to successfully navigate these uncertain systems (like the market), one must recognize that and plan accordingly. Because these uncertain systems can go sideways or down for extended periods, those attempting to navigate them must utilize "optionality," or a variety of directional choices. In other words, investors utilizing a strict, one-size fits all methodology - like buy and hold - will lose.
Optionality, as it pertains to investing, translates to many things. Among them, enacting downside protection tactics. Lowering costs. Actively managing risk. And actively allocating capital to areas that may be favored by current market or economic conditions.
Given that, we still see Wall Street perpetuating a rigid, top-down methodology that consider little to none of the above. These methods are meant to keep investors in the markets. Ride markets when they do go up. Provide time for the advisor/salesmen to develop personal (hard-to-sever) relationships. And maximize the firm's quarterly profits.
So, Wall Street continues to sell high cost, low-market sensitivity investment vehicles that offer little downside protection - even if we can see the tip of the ice berg fast approaching the bow of the ship.
Ride it out... in the long run, you'll be fine! Only, investors often end up less than fine.
Still, ascribe to 'the devil you know' philosophy, even as their prospects for financial independence suffer setbacks. While their advisor shows up in nicer ties, suits and cars.
Taleb teaches that optionality usually trumps narrative. In other words, having the option to buy, sell or hold - at a moment's notice - will usually outperform the inability to do so, the buy-and-hope mentality.
Until it finds reason to change, Wall Street will provide its sales force with "the narrative," which is a story that underscores the viability of the buy-and-hold, fast-food drive-through process.
Wall Street has mastered the narrative. Teaching brokers how to sell. Bolstering their images via slick advertisements during The Masters and NCAA tournaments. Teaching advisors how to talk clients off the roof, instead of simply teaching advisors the principles that might prevent clients from wanting to jump in the first place.
But, those principals require time and attention. All of which conflict with Wall Street's top priority: the next quarterly earnings report. It's a never-ending task master. Occuring every three months, relying heavily upon the fees gleaned from clients. Causing the firms to gravitate towards activities that perpetuate profits. As opposed to those that mitigate risks.
Of course, there are many excellent advisors within the brokerage houses. But, they are swimming against the tide. Operating in a system more focused on its own betterment than that of clients or employees.
Until the brokerage system evolves, Main Street investors will continue to pay the vigorish. The vig, the juice, the cut, the take. It represents the piece taken by bookies so that gamblers can wager on sports. It is a system decidedly in favor of the bookies.
These last five years, many of the nation's affluent investors have made this realization. Studies show that the major brokerages have lost their once-dominant grip on the nation's affluent.
A good sign? Perhaps.
But considering the words of Baltasar Gracian, the 17th century Jesuit priest and philosopher, "The wise does at once what the fool does as last."
So, while we have seen a shift since 2007, I fear that the sea change remains far ahead. That many investors will continue to ride a leaky ship, even as the waves grow larger, spilling over the gunwales.

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