How Morgan Stanley, UBS, Wells Fargo, etc. take advantage of average everyday clients and employees to feed the bottom line…
First off, let’s define what exactly we’re bashing – retail investment managers, the companies. It’s going to come up even though I am clarifying here: I am not criticizing the employees or Financial Advisors. I think they are being taken advantage of as well as the client. The industry/system is the problem here, not the clients or employees.
Retail investment management is the part of the financial industry which manages investments and retirement accounts for the everyday person/family. If you manage your own investments but have a broker/Financial Advisor, you’re still in this boat. So those are the clients, who are the culprits? Merrill Lynch, Wells Fargo, Morgan Stanley, Citibank, UBS – all of these “bulge bracket banks” have retail divisions of Private Wealth Management which employ Financial Advisors or whatever they may call themselves (Relationship Manager, Client Advocate, Portfolio Manager…the list goes on). These offices are not at the bank’s headquarters. There are retail branches in every state in America and probably every 10-25-100 miles, depending which state you reside.
So now let’s start with how these companies incept younger or first-time professionals to the industry. I’ll use the fictitious Fargo Stanley as a proxy for a typical bulge bracket bank. Most, if not all, take hiring younger Financial Advisors as buying lottery tickets. The requirements are a college degree from almost any college, ability to prove you can have a conversation in the interview, and lastly mention something about having rich friends or family members so the interviewer believes that your network includes $$$$$$$. What about managing investments or knowledge of financial markets? Doesn’t matter. In fact, the interviewer will let the candidate know that 95% of this role is sales, not investment management. From the moment one is interviewed, acquiring assets is the only thing that matters. Let me share some specific numbers to describe these lottery tickets.
These numbers are current as of 2017, and standard across the country for the most part. I know from working for one of these big-name brokerage shops. Junior hires rarely make more than $50k/year, and most are around $40k. We’ll use $50k to be conservative though. You’ll see why it doesn’t matter if Fargo Stanley’s hiring class size is 1 or 100 over time. Each new hire must pass the Series 7 within 3 months of being hired (immediately fired if you fail). Side note, the same bulge bracket banks – which also house investment banks – hire analysts from more prestigious backgrounds for their investment banking or Sales and Trading analyst programs. These new hires must also pass the Series 7 without failing…within 1 week. Given that comparison, we begin to see how low the standards are lowered in retail investment management.
Almost all new-hires pass the Series 7 and Series 63/65/66 (for state regulations) and are “revenue producing” junior FA’s within 4 months. The difference between junior and regular FA’s is that junior FA’s have monthly revenue goals to reach (see an actual grid from an unnamed bank in Figure 1 at the end of this article). Another difference is that junior FA’s are given a salary which is gradually decreased to zero if they make it through the 3-year program. Unfortunately, half of the new hires are cut within the first 6mo, and the rest are gone by the 2nd year of production. Given those facts, on average for every ten people hired, Fargo Stanley pays a NET total around $220k (after subtracting the average revenue produced by the average junior FA). Computation is in Figure 2 below. So that’s $270k for 10 lottery tickets, and we’ll see how a 10% success rate translates to a 1 in 10 chance of hitting the lottery for Fargo Stanley.
After 3 years, Fargo Stanley’s winning golden goose lottery ticket has hit at (the very) least $150k in annual revenue, and FS is not responsible for any salary going forward. Figure 3 shows a sensitivity analysis of a range of annual revenue streams using different discount rates over a 20-year span. For those unfamiliar with discounting cash flows, we are computing the current or “present value” of 20 years of revenues. Normally FA’s strive to grow revenue and reach $1mm in gross annual revenue before even higher goals. So, $400k average revenue for this golden goose over a 20 year span would err on the side of extreme caution and conservativism. Still, the value of that to Fargo Stanley…is over $2.5 million!
Hold on, the incentive to hire unqualified candidates and play the lottery is just the start of the industry’s problems. As mentioned, a new hire’s requirements to avoid getting laid off are so tough that 90% of new hires fail. The new hires need to bring in money and revenue so quickly that raising assets is not just the #1 concern over the first few years, it is the ONLY concern. Junior FA’s are so concerned with revenue – encouraged to get as many clients as possible – that they have no time to manage investments and are forced to put their clients in a pre-determined “non-discretionary” platform where Fargo Stanley chooses all of the investments. In every office-wide meeting I sat through as a Financial Advisor, management’s only objective was to convince Advisors how to meet potential clients and get their money into Fargo Stanley. When junior FA’s voiced concerns over actual investing, the managers in charge of the meeting would encourage them to allocate client portfolios to Fargo Stanley’s “non-discretionary” platform while charging the highest annual fee possible. To add to it, Fargo Stanley is in bed with the asset managers whose funds on this platform! There is a flow of money between FS and asset managers as both entities are benefitting from the relationship; this is called “revenue sharing.” The only losing party is the client in this case. After the layers of fees, subpar performance is almost guaranteed in these non-discretionary investing platforms. I have not seen a single one which has not trailed its benchmark. For more on revenue sharing, here is an excerpt taken from Morgan Stanley’s disclosure document (https://www.morganstanley.com/wealth/disclosures/pdfs/revenue_sharing.pdf):
Morgan Stanley charges each fund family we offer a mutual fund support fee, also called revenue sharing, up to a maximum per fund family of 0.16% per year ($16 per $10,000 of assets) on the mutual fund holdings of our brokerage account clients. The minimum annual fee is $250,000 per fund family but may be reduced in certain circumstances. Revenue sharing payments are in addition to the sales charges, annual distribution and service fees (referred to as “12b-1 fees”), applicable redemption fees and deferred sales charges, and other fees and expenses disclosed in the fund’s prospectus fee table.
In addition, Fargo Stanley (back to our hypothetical bulge bracket banks) has other departments Investment Banking, Research – which have relationships with 100s of publicly traded companies. As you guessed, FS’s research on these companies has a huge positive bias. The “information” which your FA uses to make “informed” investment decisions is just as biased as the “non-discretionary” platform’s investment recommendations. To avoid this obvious conflict of interest, you could find a Registered Investment Advisor which is categorized as a “Fiduciary.” These businesses are less likely to have such obvious conflicts of interest. I believe more money will flow into RIA’s as people are becoming more aware of incessant fees and subpar service from bigger firms.
Avoiding a complete tangent, let’s go back to Fargo Stanley’s non-discretionary platform. FS’s Financial Advisor is going to speak highly of their non-discretionary platform because this is where they have been trained. Instead of teaching its Financial Advisors how to invest on their own, FS only trains on how to convince clients that fees and underperforming investments are not reasons to take your money elsewhere. In other words, training concentrates on attracting clients to below average portfolio returns, and keeping clients there once they ever discover the problem. Every retail investment shop convinces its employees that their investing platform is the best, when in fact they are all equally mediocre. See Figure 4 below for evidence of how selecting winning funds is a waste of time. Out of all the actively managed funds, only about 25-30% will outperform their benchmark over 3 years. After that it gets really ugly– out of these 25-30% of outperformers, only 5% will outperform their benchmark over the subsequent 3 years! This tells you one thing, if the benchmark wins 95% of the time, then you should just invest in the benchmark. More on this when we cover why passive investing is better than active investing for any retail client.
For the few of you who believe that your Financial Advisor provides a great service even though his/her company is evil, now I have to burst your bubble. First thing’s first – we already discussed the fact that retail investment managers knowingly hire people who have no little to no relevant investing background. Then we highlighted how their training has absolutely nothing to do with investing, instead it concentrates on convincing you that you should invest and stay with them even if your returns suck. The best FA’s have actually trained you to ignore investment performance and your 1-2% management fee. They send you fancy birthday cards, Christmas cards, and butter you up so you feel bad about leaving them. In fact, if you get cards and gifts in the mail, I guarantee you are paying too much to your Advisor. Most likely you have below average returns (and don’t listen to any risk-adjusted BS – that is what money managers say after they realize they did not beat their benchmark). Unfortunately, for most of you in this case, you will probably not leave your FA because you want to avoid the difficult conversation. As a final takeaway in Figure 5 below, look at the effect of your FA’s annual fees on your long-term returns. The effects of compounding are so real that 2% in annual fees will cut cumulative 6% returns over 30 years in HALF. Even 0.5% adds up to a lot over the years, but let’s keep in mind that most people need a Financial Advisor and they must be paid something.
There are many options now which will manage your money for a fee much closer to zero – mostly accessible through the internet. All of the investments would also be in passive funds and ETF’s where you can expect to beat returns of actively managed funds over the long-term (as shown in Figure 3). Here is an article showing further proof: Why Passive Investing is Overrunning Active, in Five Charts. It is a win-win situation, and more often than not, you would also have an actual person to walk you through the website and any financial questions. This person has little incentive to convince you to do something which is beneficial for them since the system in this case provides no incentives. I will include a list of websites in a future blog, but you can easily google this as well.
Takeaway: Retail investment management shops, active investing, and birthday cards from Financial Advisors are sucking the profits out of your investments. The industry is designed to capitalize from deterioration of clients’ investment returns.