I recently was contacted by a friend who expressed his dissatisfaction with his investment advisor's performance. He wanted my recommendation as to where he should move his assets next.
My friend, who shall remain nameless, has about $2 million with a large wealth management firm, which shall also remain nameless. My friend's assets were being managed by a Financial Advisor, who charged him a percentage of his total assets under management as his advisory fee.
He also incurred fees inside of each of the funds his advisor allocated his assets to, but incurred no trading costs when money was moved from one fund to another. Net of fees, his assets are not growing at the rate of the S&P 500 when analyzed over the past decade.
Being that he has a risk tolerance and a long-term time horizon that should give the advisor the ability to outperform, or at least maintain the returns generated by the S&P over a 10-year period, his frustrations are inspiring perhaps long overdue action, and he is ready to move his assets to another management structure that, hopefully, will produce greater returns over the long term than what the broader markets can offer.
Since he is not interested in educating himself to proficiently analyze securities and implement a successful investment strategy that he could deploy on his own, and because I knew he was an accredited investor as per the definition given by the SEC, I recommended investing in a small investment partnership that is entirely focused on buying very high-quality businesses at deep discounts to what the companies' true values are.
I also suggested that this partnership should ideally hold that small collection of businesses for an extended period of time and engage in little to no short-term trading. Finally, I recommended that the partnership he should choose should not charge him an 'assets under management' fee, and should only charge a performance fee, which would be assessed only if the management company made him above 6% per year.
I then began to explain to him that the model his assets were involved in, in my humble opinion, was a model that is far more beneficial for the firm, if competitive, risk-adjusted returns is what he's interested in.
The Wealth Management Machine
First, please understand that I don't think large wealth management companies are evil companies that have malicious agendas. I worked for one of them and found most of the managers to be perfectly decent human beings. Candidly, I think the task they have, which is to prudently allocate trillions of dollars of investment capital for millions of investors, is an extraordinarily difficult task to accomplish, especially if the expectation of the owners of a material portion of that capital expects their advisor to outperform the market.
If you step back and look at the numbers, the total market capitalization of the S&P 500 as I'm writing this is about $22 trillion. According to a CNBC article,
Global assets under management reached $84.9 trillion in 2016 and will therefore almost double to hit $145.4 trillion in 2025, the latest Asset and Wealth Management Revolution report showed.
Since the pantheon of wealth management institutions (NYSE: MS), (NYSE: BAC), (NYSE: JPM), (NYSE: UBS), (NYSE: WFC), (NYSE: SST), (NYSE: FNF), (NYSE: BLK) have almost $100 trillion in assets under management, they, in total, have almost 5x more assets under management than the entire market capitalization of all the businesses inside of the S&P 500, so it's safe to say the assets they oversee make up a material component of the market.
By virtue of the sheer quantity of assets, it becomes very difficult to grow these asset sums faster than any major indexes because the assets these firms oversee in fact own a large portion of the securities that make up the index itself. Please keep in mind that I use the example of the S&P 500 just as a way to build perspective around the quantity of assets the firms have. Of course, in practice, these firms allocate capital to funds that have securities outside the S&P 500, but a material portion are inside the S&P 500.
When The Big Banks Diversify
The model that many of the large wealth management firms operate on is not the best model for prudently growing assets on behalf of their clients as effectively as possible, but is essential to enabling a multi-trillion dollar wealth management business to grow and maintain stable cash flow. The exceptions to this are companies like Vanguard, who simply get the investors access to the market at the cheapest cost possible.
As long as that asset base grows over time by the capital markets appreciating and from new money coming in, the operating margins can remain the same, causing earnings to grow, and the shareholders of the wealth management business will continue to make money through the appreciation of their stock.
It's a great business model for the shareholders of the company itself. The model also presents a stable source of predictable cash flow for large investment banks to lean on when their core businesses aren't booming, providing smoother earnings projections; an attribute that strikes great favor with analysts on Wall Street.
In mid 2013, the prestigious investment bank, Morgan Stanley (NYSE:MS), completed the acquisition of Smith Barney, a wealth management business that was hit hard by the chaos in 2008. According to an article by Aaron Lucchetti of The Wall Street Journal,
the transaction marks the culmination of a strategy to morph the once high-rolling investment bank into a safer firm more focused on the reliable fees of the wealth-management business.
Lucchetti then quoted the CEO of Morgan Stanley, James Gorman, who stated,
it brings the stability and the ballast of wealth management together with the earnings and the strength across all our institutional securities businesses.
It is my belief that the stability of fees that Lucchetti is referring to comes in large part because the high net-worth clients these firms serve don't know about the other investment options they qualify for outside of this pervasive system. Let me first explain the economic disadvantages of the system.
In order for the wealth-management businesses to allocate the massive amount of assets they have, it becomes essential to use a diversified asset allocation strategy, where a typical portfolio for a high net-worth retail investor could contain five or more mutual funds or ETFs, which individually can contain hundreds of securities.
The asset allocation strategy may include stocks, bonds, commodities, REITs, and alternative investments, and when it's all said and done, it wouldn't be uncommon for a single retail portfolio to contain 200+ securities, if you add up all of the securities inside of the various funds. Also, keep in mind that these securities are constantly changing, as some funds have 50-100% rollover rates, meaning the securities in the funds are being replaced at a rate of 50-100% per year with new securities.
The model also depends upon a very small amount of money being kept in cash and the remainder of the assets being allocated into securities that are qualified to be billed under an 'assets under management' fee structure; a cash position outside of the portfolio of funds is not qualified to be billed, typically. So, you may be asking yourself, "What's the disadvantage of their investment strategy? Diversification is a good thing!"
Diversifying Away The Returns
Since the mantra, "Diversification = Safety" has been shoved down the throats of students of finance, investment professionals, and the general public, very few seem to challenge this fundamental strategy. Notably, one of the greatest investors of all time, Warren Buffett, has a different view and was quoted to say, "Diversification is protection against ignorance. It makes little sense if you know what you are doing."
The reality is, the diversification ideology conveniently enables large wealth management businesses to broadly diversify the capital they oversee. They do this because they have to. The way they make themselves appear to be different and to add value to an investment strategy is by promoting their ability to generate alpha by intertwining whatever predominant macro play the global strategists agree on at the moment, which very often turns out to be wrong.
Another telling quote is by Peter Lynch of Fidelity's Magellan Fund, one the greatest mutual fund managers of all time, who said
[n]obody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested.
If the advisor controlling the assets of their clients invests their capital into funds that contain hundreds of securities which are being bought and sold frequently, how is it possible for them to truly oversee the performance of these managers? Can they really be paying close attention to exactly what is being bought and sold and understand why it's being bought and sold? Do the managers of the investment vehicles even know what's going on on an individualized basis inside of each of the businesses they are buying and selling? Is buying and selling securities en masse really the correct way to invest anyway? Another quote from Buffett should sum up the answers;
[w]hen we own portions of outstanding businesses with outstanding management, our favorite holding period is forever.
If generating market beating returns by exposing capital prudently to the market is what the objective is, I am quite positive there are far more effective strategies to accomplish the goal than what's being offered inside of the diversified model; the question is why the large wealth management firms still incorporate the diversification strategy into how they invest their clients' capital. After all, some of the most brilliant minds in the world work for these institutions. Take the following quick example as the economical explanation:
Let's assume rare, but wonderful investment opportunities arose in the market and have an aggregate total market capitalization of $500 billion. Perhaps these opportunities came when a handful of very high-quality businesses with lots of differentiating, competitive attributes asymmetrically decreased in price when there was a market-wide panic, caused by the actions of very poor businesses, like in 2008.
If the wealth management companies, with their armies of hungry analysts who are without a doubt smart enough to uncover and effectively instruct the advisors to buy these opportunities for their clients, bought the entire amount of shares available in the market on behalf of their clients, they would still have trillions of dollars left to allocate. This means, by definition, the participants in that system will never have entire exposure to the market's best opportunities only.
This leads me to conclude that the firms with trillions of dollars cannot participate in any other strategy expect broad diversification essentially because they have too much money to allocate. That is the fundamental flaw of the business. As such, they lean on the diversification strategy as the right one because it supports their business model. People seem to justify actions, even inferior ones, if it supports their ability to make money. Charlie Munger, the Vice-Chairman of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), called this type of irrationality "Incentive Caused Bias" and explained its various forms of manifestation in business when he gave a lecture at Harvard in 1995. I earnestly suggest listening - you can find it on YouTube.
What's unfortunate is that the investors who are in the system are of the understanding that their capital is better off in an overly diversified strategy. After all, they are just listening to the professionals. In reality, if their capital was free enough to concentrate in the best opportunities, they could be vastly outperforming the markets over time.
Call me crazy, but I'd love to own just my top 10 favorite investments that I know front-to-back and hold them for 50 years, rather than a portfolio of 200 securities, which are being traded on a moment-by-moment basis. Hopefully you can start to infer that these large institutions are fundamentally not set up for generating competitive returns. But if you're still on the fence, another telling fact that will support the argument is to note that the compensation model inside of these institutions is structured to incentivize their advisors to gather and retain assets, not necessarily make them grow from a returns perspective. I know this seems counterintuitive, but let me explain by way of example.
Incentives Drive Behavior
Let's assume the advisor at a large wealth management firm is operating off of an incentive structure that charges a percentage of the assets under management, which is what is widely being touted as the new model for financial advisors, as they claim it creates an "alignment of incentives" between the advisor and client. Astoundingly, that advisor would actually get paid more if they brought in five, $1 million accounts and made their clients 5%, net of fees annually, than if they brought in two, $1 million accounts and produced a 20% return on capital, net of fees, for their clients by focusing their time on finding high-quality investments. Why? Simple. It's more economically beneficial for the firm to incentivize growth from an asset acquisition standpoint, which will grow revenues faster, than a focus on performance as the primary mechanism to grow asset totals.
The SEC has restrictions on financial professionals using a fee-structure based on performance for non-accredited investors. Interestingly, that $20.6 trillion figure quoted earlier is entirely made up of accredited investors with capital in the model that is not based entirely on performance. This, to me, is tragic. It's analogous to someone engaging a prestigious, mega law firm to represent them in a lawsuit where they're suing for damages, the law firm coming up empty handed at the end of the lawsuit, but billing the client anyways. I don't care what the industry standard is or isn't. Why is it that people expect to be paid regardless of their ability to add value?
Firms train their advisors on how to prospect for clients and stress that building a large book of business by tapping all known associates is a great place to start, then, transitioning toward the tactful execution of a marketing campaign that sells the credibly of the firm and its "proprietary research sources." What's most important to note is that performance is a touchy subject for a great many of these advisors. As a matter of fact, some advisors entirely defer the focus on actual performance if a client calls to talk numbers.
Through all sorts of psychologically manipulative tactics that play on the client's emotions, which are enabled by the trust the client has instilled into their advisor, the advisor can walk the client from a healthy skepticism of the value the advisor is providing, to wanting to "stay the course", so they "don't have to work a part-time job in retirement", or "not have enough money to leave their grandkids to attend their dream school." It's a regrettable function of taking dissatisfaction and extinguishing it by affiliating the decision to keep the assets at the firm with generally positive outcomes, and inversely associating leaving the firm with some sort of weakness or poor decision. They use big words, sound confident, and wear really expensive clothes so you won't dare disagree. The parasitic nature of the business model is similar to the economic agenda of special interest groups, which aims to take a small amount of resources from a large amount of people to benefit a small few.
The Money Transfer Scheme
Another flooring calculation is if the total $22 trillion being managed by this system is being billed at an average cost of 1% per year (which is about the average for high net-worth investors, although it can be as high as 3%), excluding the fees inside of the investment instruments themselves, that means that on an annual basis, the aggregate wealth transfer total amounts to approximately $22,000,000,000.00, which could otherwise be spent in the economy, ultimately boosting GDP, creating jobs, innovation, etc. as the investors begin to realize those gains and spend the money.
Again, this is a powerful and profitable business, but probably not the best for the clients. I think if you're a high net-worth investor and your money is being managed under a system of broad diversification, which is incurring fees based on a percentage of the total assets under management and not the performance of the managers investing your capital, you're in a system that is not set up to grow your capital at the rate it could be growing under a truly client-centered structure which puts performance first.
It's not your fault, either. You most likely trusted the recommendation of someone who themselves believes the model is the best. I hope you have learned enough by reading this to simply conclude otherwise.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.