Updated: Dec 9, 2021
"Your margin is my opportunity." - Jeff Bezos, Amazon
It was a dreary fall evening. It must have been a Tuesday or Wednesday because there wasn't any football or golf on TV. My default background TV station is Bloomberg News. If you're familiar with the program, a vertical news ticker cycles through the daily headlines. It was the beginning of 3rd quarter earnings season. Big banks and financial services companies were the first to report.
"XYZ Bank reports strong numbers behind record profit margins in wealth management unit"
Record profit margins in wealth management, huh? I wondered aloud how XYZ Bank's clients would feel hearing about the fat margins the company is boasting at their expense.
I immediately thought of the story that inspired Fred Schwed's book, "Where Are the Customers' Yachts?". The title refers to a visitor to a New York harbor who admired the yachts of the bankers and brokers. Naively, he asked where all of the customers' yachts were? Of course, none of the customers could afford yachts, even though they dutifully followed the advice of their bankers and brokers.
The boasting of record wealth management profit margins lit a curiosity fire. What else was buried in those earnings reports? I combed through quarterly filings from eight publicly traded banks and financial advisory firms. The open secrets are there for all to see. You just need to know where to look.
Here are the common themes from my research.
Commissions are Alive and Well.
Schwab, Fidelity, Etrade, TD Ameritrade all recently announced that ETFs, stocks, and options (each firm is slightly different) are free to trade. In 2019, if you're paying front-end sales loads, outsized trading commissions, buying complicated annuities or whole life insurance, you're doing it wrong. Unfortunately, hundreds of millions of commissions are being generated from the above products every quarter.
Cross-Selling is Still a Thing
By definition, cross-selling is making other products available to a current customer. That doesn't sound so bad, right? The problem arises when a compensation plan reads "The advisor must refer ten mortgage deals per quarter to the bank's lending team." Big difference.
The Holy Grid
If you want to understand why a financial advisor wants you to do something, ask to see their compensation grid. Big brokerage firms will incentivize certain behaviors depending on what's most profitable. For example, big brokerages want clients to borrow against their investment portfolios. The firm earns interest on the borrowed money and it makes the client relationship more sticky.
In general, the more a broker produces in revenue, the higher the percentage of the revenue they keep. A broker doing $300,000 of annual revenue might keep 35% for him/herself. However, a broker doing $750,000 of annual revenue might take home 60%. That's good for the broker, but how is that good for Mr. and Mrs. Client trying to protect their nest egg? This is a classic misalignment of incentives.
One firm outlined the revenue trifecta for its advisors. The advisors charged clients an assets under management fee of 1-2%. The clients also ended up paying a commission for the securities bought and sold in the account. Finally, the advisor charged a separate annual financial planning fee ranging from $1,500 - $4,500. All of the above would be offensive in isolation let alone bundled together in a golden parachute for the advisor.
Distribution Fees Paid and Received
Out of the thousands of available mutual funds for investment, do you ever wonder how your advisor selected the funds in your account? Chances are a mutual fund company paid for the right to be on your advisor's fund menu. In exchange for the distribution fee, the advisor is encouraged to use the mutual fund. It's a version of pay to play. Rather than selecting a fund based on merit, dollars flow to the funds that pay distribution fees to the advisor's firm.
In the matrix of commissions, conflicts of interest, triple dipping, etc. we get record profit margins. Unfortunately, nickel and diming unsuspecting investors also leads to legal action. The most fined companies year in and year out are public financial services companies and banks. See Fool Me Once, Fool Me a Billion Times.
To find out if your financial advisor works at a public institution, go to Yahoo! Finance, Finviz, or Bloomberg and type in the company name. If it's public, the drop-down menu should populate and you can click on the ticker symbol.
Everything I've outlined is available on the Edgar SEC database. The database is a bit archaic, but you're looking for 8-K or 10-Q reports. The language in their own earnings reports would suggest public companies cannot be fiduciaries.
No advisor or company can serve two rulers. If it's between doing right by clients or maximizing shareholders profits, which do you think wins?
You already know the answer.