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The $50B wirehouse heist

Oct 22, 2013 @ 9:22 am

By Rudy Adolf

The result is shocking. I have done the math. Wirehouses destroy close to $50 billion in portfolio value each year. That's some 100 basis points in lost value that could be in their clients' portfolios, and isn't. It is $50 billion these clients are paying away in the form of unnecessary fees (which they may not even know are there), or depressed performance based on poor product choices, combined with high expense levels. Or both.

But why isn't it there?

The answer's really quite simple: Because if the money were there, the wirehouses wouldn't be.

Look at it this way: According to Cerulli Associates Inc., the big wirehouses manage over $4.7 trillion in client assets. One hundred basis points is the equivalent of nearly $50 billion. Assuming that just 25% of the excess pricing is retained by the wirehouse, there will be no wirehouse left.

But are you really that surprised?

As victims of their histories and their own legacies, the wirehouses have a business model that just cannot support them. And since the problem is intractable, they have been forced, among other things, to create inflated and opaque pricing structures that are then handed down to the brokers to implement. Because ultimately, wirehouses cannot sustain their businesses without this revenue stream.

When clients move their assets to one of our firms, our standard practice is to review their portfolios, and when we do, we nearly always find tremendous opportunities not only to reduce fees, but also to put them into far superior products. Three examples of egregious misallocations to clients' portfolios -- allocations quite obviously in the interest of the wirehouse and not the client -- will help to illustrate just some of what we see regularly.

First, there are high-commission structured products: Rarely is there a sound investment reason for them to be there. When is it ever in a client's interest to provide an issuer with cheap capital – without getting an appropriate return? Wirehouses virtually always sell these on a commission basis despite the existence of much-cheaper solutions designed for fee-based advisers. We've analyzed at least 100 wirehouse structured notes and found none to be in the clients' best interests.

Second, there are hugely marked-up bonds. The bonds in one pretty straightforward $40 million bond portfolio constructed by a well-known wirehouse had been marked up by $600,000 – about 1.5% on average; the client was told about the low management fee he was supposedly paying, but once he saw the real economics he moved his portfolio in a heartbeat. Third, wirehouses often significantly overweight clients in A shares, instead of other more efficient share classes. Wirehouses rarely provide clients with access to the cheapest share classes, dramatically increasing the cost of money management. We have seen total excess fees and product costs of easily 100 basis points and more, even for very affluent and sophisticated clients.

These are just three out of many examples that demonstrate that what is good for the brokerage firm is not good for the client. In each of these cases, the clients are kept in the dark about the extent of the “tax” they pay to support antiquated business models. None of these examples has anything to do with the excesses and fines imposed by regulators with a high level of publicity; these are examples of day-to-day, systemic behavior, probably perfectly legal, given the opacity of the suitability standard, but simply not in the best interests of the client.

However, I'm certainly not advocating that clients pick up the phone immediately and challenge their brokers (although taking a good look at their brokers' product selection may be essential for their financial health). They need to realize that it's the system that's at fault. Their brokers operate in an environment imposed on them by massive, anonymous organizations; every client is just a number for headquarters, nothing more. The best among the brokers go to battle every day on their clients' behalf, protecting them against yet another dictum coming from the top. (Oh, did I mention a close-to-absurd program to increase fees recently imposed by a wirehouse?) However, when brokers do decide to go independent, their clients really should go with them. It will be better for the clients. It will be better for the broker. And clients will not be alone. When really good brokers leave the wirehouses to go independent, in our experience, they usually take with them 90% to 95% of the assets they formerly looked after.

The wirehouse problem remains an insoluble one: they are not creating appropriate returns on equity despite smoke-and-mirror pricing and inferior product selection. They have been systematically losing market share for 20 years. Rising interest rates may help, but will just hide the real issue: Unless they learn to truly add value to their clients in a transparent way, their best clients and brokers will continue to move to Independence. Let's stop the $50 billion heist.

What do you think? Do you have an opposing perspective? Join the conversation and tell us what you think of the wirehouse model or e-mail our digital editor with your point of view.

Rudy Adolf is founder and chief executive of Focus Financial Partners, one of the active acquirers of RIAs nationally. An industry expert, Rudy frequently speaks at industry events and helps partner firms build their practices strategically.

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