In his investment book “Where are the client’s yachts?” Fred Schwed opens with the story that gives the book its title:
Once, in beloved days dead beyond memory, a visitor from out of town was shown the wonders of New York’s financial district. When the group reached the battery, one of their guides pointed out some beautiful anchored boats.
He said, ‘Look, those are the yachts of the bankers and the brokers.’
“Where are the customer’s yachts?” asked the naive visitor.
Although the wealth management industry has evolved since Schwed’s book was published 81 years ago, the underlying problem remains: it is, first and foremost, a money-making machine for those who work in the industry. This does not mean that the wealth management industry is made up of bad people (I am one of them!), But rather that their incentives are often not aligned with acting in the best interest of clients. As Upton Sinclair says, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”
According to Roman Catholic theology, the seven deadly sins are the primary feelings or behaviors that inspire the most sins. The wealth management industry’s misaligned incentives roughly correspond to those deadly sins, and knowing them is essential to being a smart consumer of financial services. Once you understand what drives the wealth management industry, you can better choose which advisors to work with, weigh their advice with clear eyes, and decline as necessary.
The seven deadly sins of the wealth management industry are:
1. Advisors are encouraged to provide the least amount of service possible (laziness). An investment professional I know who works in the trust department of a large bank told me that a common refrain at his bank is “don’t wake the dead.” In other words, don’t call customers unless they call you first. There is a fundamental trade-off in any business between customization and scalability. And it’s particularly serious in the financial services industry. Wealth management companies are incentivized to scale rather than customize, because the more clients they can serve with limited people and resources, the greater the profits. By ignoring clients and being reactive rather than proactive, advisors can handle large numbers of clients, charge higher fees, and increase business profitability.
2. Advisors spend most of their time looking for their next client (lust). Years ago, I interviewed a global investment brokerage adviser looking to change jobs. When I asked him why he was interested in our much smaller boutique firm, he told me that he went into the financial services business to help people, but that he doesn’t do much. “About 80% of my time is dedicated to business development and only 20% to advise and help my clients,” he said. Unfortunately, this is common in wealth management companies because they are structured so that advisors “eat what they kill.” To earn more money, they must constantly get new customers. As a result, most advisers spend most of their time searching for new clients rather than worrying about existing ones.
3. Most advisers are compensated based on income and profitability, which makes them see clients as profit centers (greed). The compensation structure for most financial advisers creates an inherent conflict of interest that can lead to poor advice. For example, when reviewing the portfolio of a new client, we noticed that he had a substantial margin loan. When asked about the purpose of the loan, he said that his previous advisor had recommended that he use a loan instead of selling investments to finance his living expenses. Considering that the advisor was compensated based on a percentage of this client’s invested assets, this advice was suspect. By recommending a margin loan, the advisor not only maintained the total fee level for the client’s investment assets, but also earned fees on the loan.
I have also seen advisers discourage clients from making charitable donations for life because it would reduce assets under management and, in turn, the adviser’s fees. Or they use a higher fee mutual fund even though the fund has a lower fee share class because they make more money at the higher fee. Similarly, many investment firms sell structured products like hotcakes because they are very lucrative for them, but not necessarily for their clients. These are just some examples.
4. Wealth managers introduce unnecessary complexity to justify their existence (anger). Investment diversification is essential, but most portfolios are packed with more funds than necessary. Why do advisers use five funds when one would suffice? One main reason is the Elusive principle, which argues that “the institutions will try to preserve the problem to which they are a solution.” If advisors design simple portfolios, why would their clients need them?
I experienced this firsthand at a seminar for investment professionals working for family offices. The 40 of us divided into six investment committees and were tasked with recommending an investment strategy for a hypothetical family of clients who had recently sold their business for hundreds of millions of dollars. The first five investment committees featured similarly complex portfolios with allocations to municipal bonds, taxable bonds, high yield bonds, distressed debt, equity index funds, actively managed funds, growth and value funds, small and large cap funds, international developed and emerging markets. funds, hedge funds of various styles, private real estate, venture capital, etc. Their pie charts were colorful and had many portions. In contrast, our investment committee, which came in last, proposed a portfolio of two funds: a municipal bond fund and an index fund that tracked the global stock market. At first, the other participants were incredulous. It seemed crazy to suggest such a simple portfolio. But when our committee asked who was sure their complex portfolio would outperform the simple one, no one raised their hand. An investment director at a multi-million dollar family office noted that the biggest problem with our portfolio was not its likely after-tax performance, but that he would have to fire his team of 10 investment analysts and possibly himself.
5. Most advisers will not say “I don’t know” (pride). The economy and the stock market are inherently uncertain. Pandemics boats stuck in canals, major pipeline attacks, terrorist attacks, Elon Musk tweets and a host of other unpredictable events affect the economy and financial markets. The wealth management industry often responds to all this uncertainty with overconfidence. Predictions of what the stock market will return and how clients should change their portfolios are the rule rather than the exception. However, the backgrounds of investment professionals show that they are terrible at making these predictions. But they continue to do so anyway. Why? One reason is that they think their clients expect them to have all the answers, so they are not comfortable being honest about not knowing what will happen in a financial system that is inherently absurd. But which one do you think is better? Investing in wrong predictions or building portfolios with the recognition that the future is uncertain?
6. Lack of transparency about rates (gluttony, more or less). This wealth management sin is more dishonesty than anything else, but it’s driven by gluttony – the desire to feed the never-ending craving for more fees. Even if your management fee is clearly stated by your wealth management company, as a percentage of assets under management, calculating the total fees you are paying is difficult. The underlying investments also charge fees, which may take a bit of research to find out. For example, when we became the family office of a client whose investments were distributed among several large banks and brokerage firms, one of our first projects was to find out how much he was paying in total fees. When we asked investment firm relationship managers, they either didn’t know or were reluctant to tell us. It took one of our junior analysts hours to review the fund’s prospectuses to come up with an answer, which was that our new client had been paying much higher fees than he thought. Because high fees are a significant drag on your investment return, doing this calculation is essential.
7. The tax burden of investments is treated as secondary or completely ignored (not exactly envy, but it is the only mortal sin left). Like fees, taxes weaken your return on investment. In fact, they are usually greater than or equal to the total investment management fees. However, the wealth management industry tends to talk lip-service about the tax burden on a portfolio. They use sophisticated software to track investment performance, but the tax burden is not something they report. Work is needed to determine the amount of taxes generated by the various investments. Advisors can use portfolio turnover as an indicator of fiscal efficiency, but that’s only a rough estimate. Assessing the actual tax burden requires reviewing a client’s 1099 forms or tax returns. Considering the impact that taxes have on returns, this is a massive oversight of the industry.
What to do with sins
Most advisers are not sitting in the office thinking of new ways to neglect and overcharge clients. Rather, the seven deadly sins are subtle; Advisors serve multiple teachers and clients are often not at the top due to misaligned incentives.
As a consumer of financial services, the most effective thing you can do is choose an advisor in a wealth management company that has been structured to minimize the seven deadly sins. To do this, ask current and potential advisors questions, such as:
1. How does your business make money? Do you receive any income from products? Any indirect compensation from some other financial firm?
2. How are your people compensated and what metrics is your compensation based on?
3. What metrics do you use to assess customer profitability?
4. How many other clients does my advisory team serve?
5. How do you incorporate tax efficiency into your portfolio recommendations?
6. Will you provide a fully transparent report of all fees my portfolio will incur?
The answers to these questions will reveal the extent to which your relationship with your advisor will be adversely affected by self-interest. You work hard for your money and you also deserve to own a yacht.