Big Firm Conflict of Interest: The Penalty Box

Its fairly well known in the traditional retail investment world that the client and the advisor often have opposing, and sometimes contradictory, interests.

I sometimes forget just how much so in my little world of boutique asset management (We charge about ~1%). A conversation with a couple of brokers from a large firm that I can’t name (hint: Rhymes with Schmerrill) reminded my just how misaligned the incentive system is, and how screwed up it must be to work at a huge, publicly traded, mega asset management firm.

To wit: These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Let me make sure I understand this: We did the right thing by our clients, and although we took a big short term revenue hit, we hope it pays off over the long run. And the firm response is to drop our payout even further? So the entire system is set up to discourage doing the right thing by the client?

(Hence, why they are talking with us).

We’ve previously discussed the misaligned compensation system of bankers and the short term incentives that led to the entire credit crisis. But did you have any idea that the entire industry was so utterly conflicted?

I find this utterly ridiculous. No wonder we get so many inquiries from (soon-to-be-former) clients of the big houses:They have been cut in half, but at least the firm got its 1% and the broker’s payout remains at 43%.

And that’s all that matters in the end, right?

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Any big firm brokers want to add their own tales of woe, please pass them along.