Investment Professional
This fall I was in the lobby of a client’s office . I was waiting to meet with him and he was running late. A salesman was sitting close by. He was waiting to see the purchasing manager. He and I were talking. He was in food sales. I am an investment advisor. He said he had a question for me. There was something he couldn’t figure out. He was puzzled over his 401(k) balance. At one point his balance was much larger than it was at the time of our meeting. Since he was still employed he wasn’t permitted to take any distributions. There wasn’t a loan provision in the plan. His balance was lower today than a few years previous. What he didn’t understand was his money had to go somewhere. Where was that somewhere?
I started to answer him but was called in to my meeting. I haven’t forgotten that man and I’ve had more time to think about what my best answer would be. Here it is:
Dear Sir,
Your money didn’t actually go anywhere. Because it was never really money. The 401(k) statement with the bold figure that you liked represented the cash value of your securities if you would have sold on that date. The statement with the figure you didn’t like showed the same thing. While we in the business use numerous analytical and rule of thumb techniques to justify the price (as opposed to value) of the market on any particular day, at the end of that day the market…and any individual investor’s account value…is based on a gentlemen’s agreement that arrives with zero handshakes. Every day we all agree what things are ‘worth.’ While we could look at market/stock valuations at any moment and determine a P/E ratio, PEG ratio, dividend yield to Treasury yield, the value of any investment at any given time is based solely on what people want to pay for it. When your value was high, the agreement was that was what your holdings were worth. That agreement was changed and was replaced by a new one that delivered the account balance you didn’t like.
Unfortunately for you—and fortunately for somebody else—there was some money to be made on the change in the gentlemen’s agreement. There may have been a “short seller” waiting for the agreement to change for the negative. No telling how long they had to wait or when they turned their short to cash but your unhappiness may have been a source of their happiness. There may have also been an investor with money (in the form of real cash) who was able to profit at your expense by purchasing your securities after they had dropped to the point where the price was below the gentlemen’s agreed-to accepted value. A reverse and increase in the market brought that investor some happiness.
Part of where your money went may also be found in the way companies select 401(k) vendors.
It’s possible your employer didn’t choose their plan vendor based on the relevant and valid criteria all plans should be guided by: structure, investment performance, total fees associated with the plan, ongoing education and communication with the plan participants. As I’ve said on many occasions, when it comes to a company selecting a 401(k) provider, somebody in the HR or finance department always has a brother-in-law with an insurance license.
Did you ever think about the fact you have two allocations to make? The money already in the plan and your ongoing contributions. Most plan participants keep their allocation and regular contributions the same. You appeared to be about 60 years of age. You may have been planning to retire in the next few years. You had the right and the ability to decrease the volatility of your current assets while maintaining the increased volatility of your current contributions. It’s possible your vendor didn’t share this information with you.
I’ve thought of our brief conversation a lot and wished I could have provided you more insight at our chance meeting.
/s/ Ken Kaszak
P.S. I do hope you closed the sale and got a new customer.
This is going to be an article about why you shouldn’t have your money invested with a “wire” house broker. The creative department, as hard as they tried, couldn’t come up with a catchy title. So let’s just get to it.
At the outset, we need to define wire house brokerages. These are the investment firms that tend to be located in Class A office buildings in the central business district, spend great deals of money on institutional advertising during TV broadcasts of golf tournaments, football games and similar events. They tend to have regal sounding names and may or may not have received bailout money from the Federal Reserve sometime during 2008.
To keep compliance officers happy, I’m not going to name any current wire house brokers. But I will name some from the long list of firms who are no more. Each of these firms was in business when I was a student of economics in college or since I’ve been in the business. They were either bankrupted out of existence, merged willingly or were forced to merge with another entity to avoid bankruptcy.
Here is the list: Blyth, Eastman Dillon/Dean Witter Reynolds/Dillon, Read & Company/ Donaldson, Lufkin & Jenrette/Drexel Burnham & Lambert/E.F. Hutton & Co./Paine Webber/ Prudential-Bache/Robertson Stephens/Parker Hunter. Recent history and fresh in everybody’s memory: Bear Stearns, Lehman Brothers. From the Current Events file: MF Global. (I won’t tell you which one of these ghost firms it was but shortly after graduating from college I marched into the office of one of them in search of a job. I was wearing the only suit I owned—a brown, double-knit polyester suit. I managed to have a 15 minute sit down with the office manager. His advice to me was to get a job selling used cars for ten years and then come back to see him. After I got into the investment business I had the unique experience of reviewing some of his clients’ portfolios. His career advice was just as bad as his investment advice).
With such carnage, why would people willingly place their money with wire houses and wire house brokers? It’s because most people don’t understand the structure of the investment banking and investment advisory businesses.
A wire house firm makes money from the following activities: proprietary trading (which may soon be curtailed if the proposed Volcker Rule is left with any teeth in it), non-proprietary securities trading (buying and selling securities for mutual fund companies and other investment entities), investment banking activities (underwriting IPOs and securities “Add-Ons”), generating fees from Mergers & Acquisition (structuring the deal, arranging the financing, etc.), and retail activities. The lowest rung of this ladder is the retail side. The selling of investments to individuals and retirement plans out of those CBD offices with the nice views may or may not be the least profitable but it is definitely the least prestigious.
The “wires” like to have retail because it gives them a way to sell securities they’ve underwritten or that they have in inventory. Many times a wire house broker will tell a client they are selling them individual bond issues but not charging them any commission. The unsuspecting client thinks her/her broker is being a nice person. Truth is that the broker knows the firm has bonds in inventory yielding 5%. They’re sold to the client at a price to yield 4.5%. Did the broker charge a commission? No. Did they make any money on the transaction? Of course. The “cost” to the investor was the premium added to the bond price to lower the yield. It wasn’t a commission but it was income generated by the advisor on the transaction. Did the client know that? Unfortunately, not. Clients of wire house firms see the institutional ads, hear about the IPOs and the merger activity in the media and mistakenly paint the retail side of the business with the same brush.
One of the classic stories from the wire houses concerns a mutual fund entity owned and operated by a well-known wire house. They’re still alive–in a different ownership form–so I won’t mention them by name. The mutual funds they operated had above average “turnover” rates. The turnover rate is an indication of how often a mutual fund manager is buying and selling securities in the portfolio. A few years ago I did a study of wire house broker-owned mutual funds. The T/O rate was in excess of 100%. The industry average T/O rate at the time was 86%. The trading department at the firm was generating revenue from the trading and was profiting from the excessive trading.
The fees generated by the trading department were in addition to the asset management fees (also above average) that the firm was deducting from the assets in the client accounts.
With the performance of the funds lagging and regulators questioning if the wire house brokers were given financial incentive to sell the firm’s own funds instead of better performing independent funds, the company decided to eliminate their name from the line-up of funds. To make their funds sound better than they were, they adopted the name ‘Princeton Funds.’
Although Princeton University had a long history of unrelated entities borrowing its name, this one really got to them. They contacted the company and asked them to select another name. They didn’t want any unsuspecting investor to think the mutual funds were connected in any way with the school or endorsed by the school. When the wire house told Princeton they had selected the name because their own offices were located in Princeton, New Jersey and that….not the University’s reputation…was the reason why the name was selected, the school directors took out a map of the area and pointed out that the wire house offices were actually in Plainsboro, a neighboring town.
Before the situation got too ugly, the wire house exchanged their mutual funds assets for an equity ownership in an asset manager. Their funds, along with the soiled name, went away.
The end of that story brings up a great point. Some of the wire house brokers are publicly-traded or a part of a publicly-traded entity. Their ownership is in the hands of the stockholders. A client of a publicly-traded brokerage firm will always take a back seat to the owners of the company (same concept applies when having your money placed in mutual funds with a publicly-traded manager).
Few outside individuals understand one of the most important terms investment brokers and advisors live by: “payout.” It refers to the percentage of each dollar of sales commission or annual fee generated by a broker or advisor that is paid out to that advisor/broker. It is how investment individuals make their money. It is shocking even to me…an insider in the business…what the payouts are for wire house brokers. A partner in a recruiting firm (who left the business to become a recruiter) told me that a broker generating above average revenues may be receiving a 35% payout. The house (in this case, wire house) keeps 65% of the revenues generated by the advisor. One of the larger wire house firms just announced that any broker generating less than $250,000 in gross commissions will be cut to a 20% payout. I’m not going to reveal my exact payout but I will share that it is more than 2.5 times that of the typical wire house broker.
The problem with the low payout is that many advisors are forced to do things to clients to generate more revenue. They may sell the client into different commissionable mutual fund families just to generate a payday and may constantly buy and sell securities from an account to keep their commission flow going. I used to deal with a CPA who passed away in 2011. He told me that the only black mark in his career was in his dealings with a wire house broker to whom he had referred almost twenty clients. Each year, one of these clients would come into his office with pages and pages of buy/sell transactions confirmations from that broker. It was as if the broker chose a different client each year to “churn” in order to generate revenue. With such a low payout, the broker had to do such things to make his commission quota.
What does a wire house broker receive in exchange for their low payout? A desk, a place to meet clients, a shared secretary, free coffee and, according to one wire house manager, clients.
A wire house broker once told me he went into his supervisor’s office and asked for an increase in his payout. The supervisor declined the broker’s request. To add insult to injury, the broker was told that the only reason he gets clients was because of the name of the firm where he drank his free coffee. The clients were coming there because of the name of the firm;not the broker’s knowledge and abilities. These clients are the exact individuals I talk about when I say most investors don’t understand the structure of the investment business.
During 2008 when some of the better known wire houses were under fire for their activities in the subprime mortgage arena, many of their brokers wanted to go to independent firms. They would have increased their payouts dramatically and gotten away from the bad publicity associated with their employers. These brokers were offered large retention bonuses to stay at their firms. These are the firms that received large bailouts from the Federal Reserve. I made a few attempts to find out if the retention bonuses were paid from the bailout funds but nobody wanted to answer my question.
Ken Kaszak is a Registered Representative with Trustmont Financial Group and an Investment Advisory Representative with Trustmont Advisory Group. He is the author of How the Investment Business Really Works and a former CPA-certified instructor. He can be reached at 412-390-1122.
This piece is based on a story a client told me. When people tell me they’re happy with their financial advisor, I no longer roll my eyes. I just give them a copy of this article to read. This article is near and dear to me for a few reasons. The main one may it’s the first one time I used the phrase “You don’t know what you don’t know.”
Ron Morris was the founder of the American Entrepreneur radio show. He provided me with countless hours of insight and entertainment. Ron battled liver cancer for many years until succumbing to the disease in June of 2012. I wrote this piece and submitted it to Ron’s staff so that Ron could take a week off from writing his Friday afternoon “email blast.” I had an unusual relationship with Ron and had the opportunity to share and discuss movies with him. If I’m in my office at 3:00 during a weekday, I wish I could turn the radio on and hear him again.
I wanted to use one of my favorite words, epiphany, in the title. It didn’t make it there but found its way into the first sentence. I was trying to determine which criteria were valid and relevant in determining when to enter and when to leave the stock markets. The finding was an epiphany for me.