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The Extraordinarily High Cost of Investment Advice

23

Some years ago my cousin Bob, an oral surgeon in a midsized American city, told me someone was trying to sell him investment services. He wanted my thoughts on the matter.

A woman in his city, a local consultant with a large national investment brokerage firm, was calling him regularly to convince him to place his pension fund’s assets in her company’s wealth management program. Bob seemed to be responding to the marketing effort. He was considering entrusting the pension fund assets—about $1 million at the time—to the brokerage firm for advice and management. But he knew I might have a different view, and he wanted to know what I thought. Also, he knew I had a business involvement with her brokerage firm and thought I would be interested to know about the calls.

First, I told Bob never to tell anyone at the brokerage firm that I told him this. At the time, I had a fat contract with the firm. Its consulting division was making heavy and expensive use of a computer system in which I was a 50 percent partner. I had a good relationship with—and liked—the employees at the firm that I did business with, the people running the consulting division. Bob’s suitor presumably worked for that division. Of course, I didn’t want them to know I was working at cross-purposes. But I also didn’t want to give my cousin a bum steer.

In response to Bob’s inquiry, I quickly made a brash and ill-considered statement. I told Bob that if he hired the woman and her employer, his pension fund would have $1 million less when he retired than it would if he did not hire them.24

Right after I told him this I felt a little sheepish, because I had made a quick statement about a matter of mathematical fact without really having done any calculations. I tossed the $1 million out without thinking, because I thought it would get Bob’s attention. But then I went back and carefully did the calculations.

I was wrong. I had underestimated by a factor of three. He would have $3 million less if he hired the brokerage firm than if he did not hire them.

Here are the numbers. Bob’s pension fund had about $1 million at the time. When it later paid out to retirees, in about twenty years’ time, it would have to cover not only Bob but also his partner—another oral surgeon—a receptionist, and several assistants.

A reasonable assumption was that contributions to the pension fund would be about $100,000 a year for the next twenty years. In a long-term portfolio, a heavy weighting toward stock is desirable, and a return of 8 percent a year was—and is—a reasonable expectation.

A simple calculation, simple at least for those familiar with compound interest formulas—and readily available on popular handheld financial calculators—shows that at 8 percent return, Bob’s pension fund would grow to about $9.6 million in twenty years.

Now let’s deduct the fees the brokerage firm and its investment managers would charge. Total fees levied by the brokerage firm at the time were typically 2.5 percent a year. Most things about investment are unpredictable, but fees are highly predictable.

Deducting 2.5 percent from 8 percent leaves 5.5 percent. Performing the calculation again, we find that the same assets and contributions would grow at 5.5 percent in twenty years to about $6.6 million.

Without fees, $9.6 million; with fees, $6.6 million—a predictable difference of $3 million.

If you think this is a phantom figure—a mere hypothetical might-have-been, as in “If I had only invested $1,000 in Microsoft in 1986, I’d have $200,000 now”—remember that the brokerage firm would actually receive this amount. And it would come right out of Bob’s account. Over twenty years, my cousin’s payments to the brokerage firm would have accumulated to $3 million (see Exhibit 2.1). Almost a third of his assets, and almost half his investment gains, would have gone to pay the advisors.

Exhibit 2.1 Bob’s Wealth Accumulation before and after Fees

Fees of 2.5 percent may not sound like a lot, but $3 million is a lot. Yet that’s what the 2.5 percent fees add up to. Now do you wonder how the brokerage firm and others like it can afford all those two-page spread-out ads in glossy magazines and those commercials on television that we are peppered with? And they still have plenty of money left for expensive offices in the most expensive parts of cities, expensive travel and expensive conferences, and very expensive awards for the best salespeople, and extraordinarily high compensation packages. It’s done with your money, all the better to sell you their services with.25

It’s understandable that people would not realize that 2.5 percent of their assets is a lot of money. After all, the stock market’s returns seem to fluctuate so widely that the difference between the return from one year to the next can be 10 or 20 or 30 percent or more. So what is 2.5 percent compared with that? But the 2.5 percent going to fees is a sure loss, while the other fluctuations average out in the long run and are unpredictable.

The selling point, of course, is the assumption on the part of the buyer that the investment advice and management will add more than it costs. That means it will have to add more than 2.5 percent per year, on average, than if Bob had just put it in the lowest-cost alternative, to be worth the cost.

What I shall show in the rest of this book is that investment advice and management does not add 2.5 percent per year. It does not add anywhere near that per year. In fact, what the evidence clearly shows is that the expert investment advice and management the brokerage firm’s representative was selling my cousin Bob would add nothing at all to his investment results.26

Investment managers are often divided into two main categories. Those who try to beat stock market averages are called active managers. Advisors typically recommend higher-cost, active managers. Those who do not try to pick stocks to beat market averages are called passive managers. They manage passive vehicles, the principal example of which is index funds.

I recommended to Bob that he invest his pension fund assets in a total market index fund, which at that time would charge him a fee of about 0.2 percent. (Fees for index funds and their sisters, exchange-traded funds or ETFs, are now 0.1 percent or less.) For that he didn’t need to pay an advisor, didn’t need to pay anything except the 0.2 percent per year. I don’t know for sure what he did, but I hope he took my advice. I expected nothing and got paid nothing for saving him $3 million. Aside from the fact that he was family, it’s hard to charge much for advice that’s so simple. However, though I offered to pay my cousin for his oral surgery, my daughter did get her wisdom teeth extracted free of charge.

The Amazing History of Brokerage Fees

Excessive fees have always been a major issue in the investment field. It can be argued that the practice of overcharging used to be worse than it is now. Indeed, in many ways, it was. But far fewer people participated in the stock market a generation ago. And evidence that value added is minimal to none has continued to mount over that time.

About thirty or thirty-five years ago, most investment advice was delivered by stockbrokers. Their fees were the brokerage commissions they received on the purchase or sale of individual stocks, or commissions on sales-fee-loaded mutual funds. Commission rates for buying or selling stocks were much higher than they are now—ten times higher or more. Because fees for buying or selling stocks and mutual funds were the only ones brokers received, their fees were called “transaction oriented.” To collect fees, brokers had to be transaction oriented themselves—that is, they had to urge clients to do a lot of buying and selling, to “churn” their portfolios.

Churning a portfolio racks up high commissions with resulting losses to the portfolio. It is “speculation” as opposed to “investing”—investing involves sticking with a company for the long haul because its long-term prospects are good; speculation is fickle, trying to grab a big profit and run.27

May Day

Until May 1, 1975, the New York Stock Exchange (NYSE), which is run by its member brokerage firms, thoroughly dominated stock trading. It allowed only member firms to trade its stocks. It required all brokers who traded on the exchange to charge fixed, high commission rates. The NYSE claimed that competition in commission rates would be destructive to the industry. And for many years the government regulatory body, the Securities and Exchange Commission (SEC), assented to these fixed rates.

Not being able to compete with each other on prices—that is, commission rates—brokerage firms competed by offering extra services, sometimes obtained from third party providers. The extra services usually carried a charge in the form of “directed brokerage” or “soft dollars.” That is, to purchase a service, such as a research report, a customer of the brokerage firm was required to do a certain amount of trading. Buried in the exorbitant profit from the trading commissions was the cost of the service.

This is why the employer on my first job, A. G. Becker & Company, could charge such high fees for a single book full of statistics, graphs, and charts: $20,000 for a corporate pension fund and as high as $30,000 for a money management firm. Becker’s clients had to pay the money to some brokerage firm for trading commissions anyway. Becker tried to beat out other brokerage firms for the business by bundling in extra services for the money.

This whole soft-dollar payment system became so messy and ridden with conflicts of interest that it was finally recommended that fixed commission rates be abolished. The NYSE fought this abolition tooth and nail, because its member firms were making so much money on the fixed rates and were using the system to maintain their exclusive club. But finally, on May 1, 1975, the SEC prevailed, and fixed commissions were abolished. “May Day,” as the action was called because of the date it occurred (but also as an Orwellian reference to the Soviet Union, cooked up by the opposition forces), contributed heavily to changing the nature of the business from a transaction-oriented business to something else—something initially much better in many ways. But perhaps inevitably, reform gradually spawned its own new corruption.28

Lower Brokerage Fees for Trading Stocks

When fixed commissions were abolished, discount brokerages like Charles Schwab were born, competing for brokerage business by drastically reducing commission rates. The cost of trading stocks became much, much lower.

“Full-service” brokers claimed their high fees were justified because their services included not only trading stocks but also recommending good stocks to their clients and telling them when to buy and sell them. The brokers claimed implicitly that they could add value to their clients’ portfolios through their stock tips.

But it was long suspected, because of an abundance of anecdotal evidence and some statistical evidence, that the brokers’ recommendations actually added little or nothing. So, many clients fled to the discount brokerages and began to make their own stock decisions.

The full-service brokerage business, of course, fought to hang on. A biography of Charles Schwab and the discounted brokerage firm he created, Charles Schwab & Co., by John Kador, gives an entertaining account of this struggle:

[W]hen Schwab lowered trades to $29.95, Fortune Magazine reporter Katrina Booker overheard a Merrill Lynch broker’s side of a telephone conversation with a customer. These are the Merrill Lynch broker’s exact words, as reported by Booker. For fun, I took a guess at what the other side of the conversation must have been like. The exchange might have gone something like this:

MERRILL LYNCH BROKER: “I can’t believe this. Suddenly you’ve got $29.95 trades, and you’re empowered.”

MERRILL LYNCH CUSTOMER: “Look, I know what I want to buy. I don’t need to pay for research. Why should I pay more than I have to?”

BROKER: “Okay, fine. You want to trade on the Internet? Fine. Go right ahead. You have to do what’s right for you. Just don’t expect much service from me.”

CUSTOMER: “We go way back. Why are you taking that tone?”29

BROKER: “Why? Because I get goose eggs! I don’t get paid, okay? So don’t expect me to give you any more ideas.”

CUSTOMER: “When was the last time you gave me an idea? I know what I want.”

BROKER: “I have given you ideas. Okay. Maybe I haven’t been as good about that as I could have. Starting today, that is going to change.”

CUSTOMER: “Listen, you guys have got to wake up. Why should I pay you $250 when I can get the same trade for $29.95? It’s a new game out there. Get with the program, or I’m history.”

BROKER: “Look, I’m sorry. I didn’t mean to piss you off. Hey, you want to go to the Mets game tomorrow? I’ve got tickets.”

Here we get a glimpse of the old-boy networking and schmoozing that cemented the high commissions in place for so many years. Booze, ball games, yacht outings, and dinners lubricated the relationship between brokers and their customers. Entertainment, more than investment research, often proved to be the traditional stockbroker’s fiercest weapon. A pair of seats on the 50-yard line combined with an occasional stock tip could beat cheap trades any day. But brokers soon learned that investors are fickle: most will go where they can execute trades for less.

The fat commissions had fed an excessive lifestyle that was frequently lampooned by jokes and New Yorker cartoons. Chuck [Schwab] begins his first book, How to Be Your Own Stockbroker, by telling a broker yacht story.

I’m reminded of an eager-beaver stock salesman I knew in Florida who took a prospect to the harbor at Palm Beach. As they surveyed the various luxury craft floating before them, the salesman pointed out all the yachts owned by successful brokers.

“But where are the customers’ yachts?” the prospect innocently whispered.1

The cash cow of the full-service broker was being killed. But a new and even better cash cow arose to replace it, albeit one that would serve a new, initially reformist, but ultimately exceedingly well-paid breed of investment service professionals.

The decline in dominance of the full-service broker, together with the fact that brokers were already under fire for causing their clients to churn their portfolios, led to a search for new ways for investment advisors to collect fees. This search helped create, and coincided with, a number of developments, many of which were good for the investor—at least up to a point.30

A mutual fund industry grew to prominence that allowed small investors to invest in a widely diversified array of stocks, rather than just a few of them. This enabled small investors to reduce, through diversification, the risk of stock ownership.

Initially many full-service brokers offered these mutual funds to clients, taking large front-end “load” fees for themselves, on the order of 7 or 8 percent. But in due time “load funds,” which were sold aggressively, acquired a bad name because of this front-end charge. The public became aware that no-load funds, which were not sold aggressively and therefore required no front-end sales charge, were a better deal.

So the gouging practices of the old full-service brokers were exposed and the public became aware and warned against them. Some, though, survived to cater to those who still believed they were being well served.

The New Percentage-of-Assets Fees

A new array of advisors and new forms of payment arose in response to the ethical crisis. It was intended to repair and move beyond the overcharging practices of the full-service brokerage industry. It was to provide new and better services to clients, with payment systems that made the interests of the advisor and the interests of the customer coincide.

In moving the payment system away from the one-shot brokerage commission charge and the one-shot mutual fund load charge, the burgeoning new array of service industries and professionals discovered something even better—the continuing, year-after-year percentage-of-assets charge.

In the brokerage business, the “wrap fee” was invented. The idea was to charge the client in a manner that had nothing whatever to do with how often or how much the client traded. It was also intended to “align the interests of broker and client” by giving them both an incentive to make the client’s assets grow. The fee would be a fixed percentage of the client’s assets and would include, or “wrap up,” all broker services under one fixed fee—hence the “wrap” terminology. The typical fee quoted was 3 percent of investment assets, per year—and remember this is 3 percent of the investor’s total assets, every year, whether it is an up year or a down year, not just of growth.31

The interaction of these investment advisors with clients became a routine. First, the advisor gathers information about the client’s assets, particularly investment assets. Then, the advisor does a “risk assessment” with the client, to determine how much investment risk the client is willing to take. This leads to an overall strategic asset allocation, a percentage allocation to stocks and bonds. Clients willing to take more risk get more stocks; those who are more conservative get more bonds. Then the advisor recommends a “style allocation,” in which percentage allocations to categories of stocks, like “large growth stocks,” are recommended. Finally, the advisor recommends specific mutual funds (or, these days, possibly separately managed accounts as opposed to investments that are commingled with others’ assets, as are mutual funds).

The wrap fee charge is typically quoted as 3 percent but then discounted back to 2.5 percent or less, depending on the size of the account.

Of the wrap fee, about 1 percent goes to the advisor (much of it usually to the advisor’s employer rather than to the advisor personally), about 1 to 1.5 percent to the recommended mutual funds, and the rest for various other purposes. Sometimes the fees are not wrapped but “unbundled,” so that the client pays the advisor’s fee, plus whatever happen to be the fees of the mutual funds, plus the other costs.

Almost all mutual funds have no front-end load now, because buyers became aware that it was better to buy no-load funds than load funds. But the mutual fund industry managed to get another, even better fee substituted for the load. By arguing that a start-up mutual fund needs to charge an extra fee to cover marketing to become known, the mutual fund industry got the SEC to approve what are called 12b-1 fees; 12b-1 fees are an annual charge to customers, supposedly to cover the marketing of the fund. Much of this fee is often remitted back to the advisor who recommended the fund, causing a conflict of interest—advisors have an incentive to recommend the funds that remit back to them. (Some mutual funds do not remit back. Low-cost index fund providers, for example, will not remit anything back to a broker or other advisor who recommends their funds.)

By the original argument for 12b-1 fees—that they are needed for marketing to get a fund started—it would make sense that they be phased out as the fund becomes big. But they are not phased out. They are in part responsible for the fact that mutual fund fees are larger than they ever were. The typical mutual fund fee is about 1.5 percent of assets—and that doesn’t even include the cost of commissions for trading within the mutual fund, which could add as much as 0.5 percent or more.32

Financial Planners, 401(k)s, and the Advisory Service

In addition to the new wrap-fee brokerage business, a new breed of advisor arose independently: the financial planner. Financial planners assess the whole financial plan of a customer and assist with it and make recommendations. In practice, their recommendations usually consist mostly of investment recommendations, because that’s where the fees are and that’s what excites their clients. Hence, their routine becomes much the same as that of the wrap-fee broker. Financial planners can be almost anyone. They could be certified by one of the big financial planning industry organizations, or they could be certified public accountants (CPAs), or lawyers, or psychologists who add some financial planning knowledge to their repertoire, or even astrologers, or just someone who hangs out a shingle.

Both the financial planning and the wrap-fee industries grew rapidly in the 1980s and 1990s. They did their clients an important service by getting them to diversify their investments using mutual funds and by making them comfortable increasing their investments in stocks as a long-run investment. Their growth coincided with—and may even have done much to nourish—the stock market boom of the 1980s and 1990s. They rightly attempted in the late 1990s to beat back the rising lure of “day trading”—that is, frequent buying and selling of a small number of stocks—churning again, with lucrative profits to the brokers, even at the now much-lower fees.

The rise of the wrap-fee and financial planning industries also coincided with another development that encouraged investors to exercise choice in their investments—the 401(k) plan. The term 401(k) refers to a section of the U.S. Internal Revenue Service tax code that went into effect on January 1, 1980. An employee benefits consultant named Ted Benna realized it could be used to design an employee benefit plan in which employer and employee contributions could be added tax free. The employee would have control over the plan’s investment.33

Corporations quickly realized that the 401(k) plan could save them money and the risk of investment, transferring that risk to the employee. The number of 401(k) plans increased rapidly, rivaling the conventional defined-benefit pension plans. As a result, many employees were faced with the decision about how to invest their 401(k)s. The demand for advice to help make that decision created more business for the investment advisory industry and introduced more of the U.S. public to investing in equity mutual funds (stocks are sometimes also called equities). The 401(k) investment decision was often included in the advisory process provided by a financial or investment advisor, whether the advisor was a financial planner or a wrap-fee broker.

Hence, the advisory service’s value lay essentially in advising the customer to make a long-run commitment to a diversified stock portfolio. This is simple advice, easily followed. The rigmarole of risk assessment, asset allocation, style allocation, and selection of mutual funds or separately managed investments, and the frequent tedious repetition of the claim that “sophisticated” models and software are used to arrive at the recommendations, could be regarded as the window dressing necessary to get the customer to come in and get the simple advice he or she actually needs. From that viewpoint the whole process is valuable.

The question, though, is whether it is not only the window dressing to get the client to listen to good, simple advice but also the smokescreen set up to fool the client into believing the advice is much more complicated than it is—and therefore worth the enormous fees charged for it (albeit to the blissful disregard of the client).

“I’ve Never Been Able to Get More Than $3,000 from That Account”

A simple incident I witnessed shows what a boon the continuing, year-after-year percentage-of-assets charge is to the investment advisory and management profession.

In the last half of the 1990s and the early 2000s, I was a partner in a firm that catered to the investment advisory industry. We did not actually advise investors ourselves. Rather, we were the support system for the independent investment advisor.34

Most investment advisors work for a big firm like Merrill Lynch, Smith Barney, or any of a number of other brokerage firms, banks, or other financial institutions. The big firm provides everything the advisor needs, including office space and equipment, sales training, computer systems, back-office paperwork and reporting, research reports, trading and custodial services, and so forth. But as the price for receiving this support, the advisor hands over to the firm at least half of her revenues from customers. Furthermore, the advisor does not own her “book of business”; that is, she can’t sell it to someone else if she decides to move into some other business or retire or bequeath it to her heirs. (The advisor’s book of business—her list of customers—can be of great value.)

Some advisors, though, can be independent of these large firms. They can set up their own business, get their own offices, keep most of the revenues from their customers, and sell their book of business if they want to. But they still usually need much of the support systems that employment by a big firm can provide.

What My Company Did

My company provided those support systems, charging a fee as a percentage of the assets invested by our clients’ customers. We provided computer software systems to our clients—the independent investment advisors—to help them go through the usual risk assessment and asset allocation process, to help them automatically fill a recommended portfolio with recommended investments, and to automatically fill in all the required forms for them.

We provided various back-office services and sent out, on behalf of our clients (the advisors), regular reports to their investor-customers on the state of their assets and their rates of return on investment. We provided research reports and gave guest talks when requested. As the chief economist, I wrote occasional papers on economic and market issues and, when asked to (and when the client was a big enough client, that is, had a big enough book of business), gave talks to groups of our clients’ investors and prospects. We also had a ghostwriter who would write articles that our clients were permitted to submit to their local newspapers or magazines under their own names.

At first we aimed for the “cream of the crop” of advisors, the broker-consultants who worked for the large “wirehouses” (the term is of historical derivation) like Merrill Lynch and Smith Barney. These people would generally have the largest books of business and would be most polished at selling and servicing clients. We hoped to have a relatively small but elite clientele. But it turned out to be more difficult than we expected to wheedle them away from their cushy situations. They were not used to furnishing their own offices. They asked silly questions to show that they didn’t know how to do it, like “Where do you buy a Xerox machine?” Furthermore, and probably most importantly, they were locked into their big firms by stock ownership or stock options in their firms that didn’t vest until years hence; in other words, they would lose the stock if they left.35

Plan A was not working quite as we hoped, so we were forced to cast a wider net. Instead of limiting our clientele to a small number of the crème de la crème, we had to increase it to a large number of the not-so-creamy. Eventually our clients included not only a few brokers who left the wirehouses to go independent but also a number of financial planners of all stripes, CPAs, and others.

A Web of Business Alliances

One day toward the end of the boom market years of the late 1990s, I went to Minnesota to give a talk at a luncheon attended by the customers and prospects of a client of ours, a Minneapolis independent advisory firm. Besides speaking at the luncheon, I was also scheduled to join in a two-hour meeting with our advisor-clients and members of a local law firm. Our clients were trying to form a stronger relationship with the law firm.

This get-together helps illustrate the complexity of the relationships that can exist in the investment field. It’s all about relationships and selling. The principal purpose of the relationship of the advisory firm with the law firm was to send each other business. It is a form of business prospecting. The more relationships you have with people in business, who know you are looking for more business, and who are also looking for more business, the more business you are likely to get.

Investment advisory firms have the advantage in this game that their clients are, in general, well-heeled. They are the sort of people who can afford expensive lawyers and whose businesses—the ones that brought them the money they have to invest—may need expensive lawyers. Furthermore, people who go to an advisor for investment advice frequently tap the advisor for other advice, like a recommendation of a good lawyer. The advisor is likely to recommend the lawyer who sends the advisor the most business. Similarly, clients of lawyers may also ask the lawyers for advice on other matters, like who is a good investment advisor. The lawyer is likely to send the client to the advisor who sends the lawyer the most business. And so it goes.36

We Go After the CPAs

In the particular case of the Minneapolis investment advisors and the Minneapolis law firm, the law clients that the advisors—and we—were courting were the CPAs. CPAs hold sway over many of the decisions made by their clients about their finances. Why not advise them on their investments, too? If our client—the Minneapolis advisory firm—and we could recruit some CPAs to become independent investment advisors under our tutelage, and within our business network, then they could add to their revenues, and we could take a small (but substantial in dollar terms!) percentage.

In short, we wanted the law firm to help us recruit those of their clients who were CPAs to become investment advisors—because then they would use my firm’s services and pay us fees.

This was not the first meeting of our advisor-client and the law firm. Rather, it was just an occasion for another meeting in the process of getting to know each other better, given that a representative of my firm—me—was in town.

They Were Wined and Dined

The advisors and the lawyers had, in fact, already met with CPA-clients of the law firm, had given them the pitch to add investment advisory services to their repertoires, and had then wined and dined them. (The more things change, the more they remain the same. Entertainment, more than investment research, is still often the advisor’s fiercest weapon.)

Looking back on the process of pitching one of the CPAs on getting into the investment advice business, and then wining and dining him, one of our advisors told the following story.37

When they met with the CPA during the day, they explained the whole investment advisory process—the risk assessment, the asset allocation, the selection of investment managers, yada yada. They used one of the CPA’s clients as an example, a man with about $3 million in investment assets. They explained about fees—how the advisor’s fee is 1 percent of the investor’s assets, my firm’s fees were whatever they were, the investment managers’ fees were whatever they were, and so on.

Later on, they were having dinner with the CPA. They were no longer discussing the client with $3 million in assets. They were in the middle of the appetizer and having an exciting discussion about some sporting event or other, when the CPA suddenly stopped and said, “Wait a minute!”

The others at the table said, “What?”

The CPA said, “One percent of $3 million is $30,000!”

“That’s correct,” said the others.

Then the CPA said, “I’ve never been able to get more than $3,000 out of that account before.”

Sale made. The CPA had seen the light—he had seen the power of the “small” annual percentage, charged every year. Charging for just doing tax returns, $3,000 was all he could ever get. But advise the client on how to invest his $3 million, and presto! Suddenly you’ve got $30,000 every year—and growing. What a business! What an opportunity! For the advisor, yes—but for the client?

And here I was—willy-nilly, like so many people in the industry, a part of the whole scam.

But little was I to realize that—as expensive as the investment advisors we were trying to recruit would be when they joined the party—they would be nothing compared with another group of investment “helpers” whose gravy train was about to arrive for real.