I had a fascinating conversation with an old friend who has been working in a giant bulge bracket firm his entire multi-decade career. What made this particular conversation so intriguing was his sudden epiphany about the Sell-side.
Our previous discussions (debates really) were over the traditional model of brokerage I push back against versus the fee-based fiduciary asset management I embrace. My examples of overpriced, low-performing, abusive account management have been derided as outliers. His counter has been that responsible brokers (like himself) run a transactional business for clients who want those services. He has high client retention and has generated respectable performance for those customers.
What led to his realization was an exit from his firm by a senior broker. As often happens in these circumstances, the ex-employee’s book gets divided up among the remaining brokers, whose jobs that weekend becomes retaining those accounts and their assets. My friend manages hundreds of millions of dollars and has eschewed this side of the business. He has been senior enough to not have to partake in this traditional Sell-side feeding frenzy. But since it is the end of summer, and there is light employee availability, it led to his getting assigned some accounts to call.
What he saw stunned him:
The previous broker outsourced much of his asset management to third-party managers; Digging into the specifics he was gobsmacked by the details: Sub-$1m accounts charged 1.25% for a high turnover, actively managed SMA which lagged its benchmark by a few 100 basis points.
Where things really get wild were the details of the SMA itself: over 200 holdings, many of which were but a share or two. The turnover was also mind-boggling: there had been 800 transactions year-to-date; if we assume a sell for every buy, that’s still a >200% turnover rate (and the year still has 4+ months to go).
He was aghast over this. This made me chuckle, as we had discussed this level of unsuitable and inappropriate asset management for years, with me offering an endless parade of examples. But since it’s not how he runs his clients’ money, his assumption was my examples were the worst of the worst (and they often, but not always, were). Having now perused this book of business, asking questions of other brokers and managers, he realizes that this is how too much of the Sell-side handles a substantial swath of its customers.
We have discussed Closet Indexing and why owning hundreds of stocks seems to be pointless versus owning a broad index. Say what you will about Cathy Woods and ARKK, but a concentrated portfolio like hers makes more sense as a satellite to Vanguard’s Total Stock Market Index ETF (VTI) or the S&P 500 (SPY) versus this unholy mess of high-cost high turnover SMA.
I reminded him that the Buy-side is regulated by the SEC, while the Sell-side is self-governed by an SRO.1 In fact, the history of the NASD-R is one of an industry working hard to prevent close oversight by the government and to protect the largest of its members. it has always been historically fraught with conflicts, anti-competitive behavior, and worst of all anti investor behavior. This was epitomized by the NASD-mandated private arbitration for disputes between investors and brokerage houses, which has a rich history of pro-industry, anti-investor bias, and fraud. If it didn’t screw so many investors out of their money it would have been a joke.
But I digress.
The Sell-side has slowly come around to fee-based asset management, as opposed to transactional business. The joke is the BD business model has replaced “Churn ‘em & Burn ‘em” with “Net ‘em & Forget ‘em.”
This isn’t really a fair accusation. There are large parts of the Sell-side that figured out It’s a much cleaner business model to charge a reasonable fee for straight-up asset management and financial planning, rather than playing the game of stock picking sector rotation market timing and the like. Doing this puts the probabilities more on their side, with the bonus that fewer regulatory headaches, legal liability, and compliance issues occur – they more or less go away if you manage this kind of model properly.
Now if only the Sell-side would get religion about fiduciary standards, I would stop hating on them so much.
They can’t help themselves, as too much money is up for grabs from syndicate, leveraged loans, underwriting, annuity sales, investment banking, IPOs, wrap accounts, and other forms of financial engineering that have all historically accrued to the benefit of the brokerage firms.
There has been substantial progress made, driven not by government regulation, but by marketplace competition. Registered Investment Advisors (RIAs) have pulled trillions of dollars away from the Sell-side and into a much more investor-friendly way of doing business.
It’s just a shame it’s taken so long for so many within the industry to notice…
Bill Miller: Closet Indexers Are Killing Active Investing (October 28, 2016)
First Rule of Running Other Peoples’ Money? Do No Harm (March 20, 2016)
1. The SEC has oversight over both the Buy-side and the Sell-side also, but most of the heavy regulatory lifting for the Sell-side is done by the industry itself.
“Put Some Lipstick On This Pig”