In 1990, the major stock brokerage firms introduced investors to the possibility of money management for the masses. Here is why that concept will vanish within a decade and what you can do to protect your portfolio.
How it all Began
Seventeen years ago I was a young stock broker at Shearson Lehman Brothers. Our weekly sales meeting had a visitor. He was a Consulting Services Department employee from our New York City office. He came to share with us the concept of “Wrap Fee Money Management.” The “Wrap Fee” system offered the client a comprehensive array of services (brokerage, advisory, and management) for a single flat fee. Brokers and money managers would now work together to provide the client with increased value. We were encouraged to hire, and work in tandem with the very best money managers in the marketplace.
High Fees and a Down Market
The majority of the stockbrokers at that time would have nothing to do with this new concept. They felt uncomfortable about the prospect of turning over control of their client relationships to another party (money managers). Stockbrokers are notoriously territorial and suspicious of new ideas about how business is done. By 1992, few stockbrokers had even considered the idea that there might be a better way to assist their clients. In addition, the brokerage firms tightly controlled the fees that the client was charged. Typically, the standard fee was a huge 3% of the client’s assets with the stockbroker retaining the option to “discount” that fee to 2.25%. As a result, during the soft years of 1992-1994 when the market gained less than 6% per year, investors experienced very little appreciation in their portfolios.
The Bull market Begins
In 1995 the market took off along with the performance of money managers and mutual funds. As a result, brokers had more flexibility to lower client fees. Beginning in 1992, I was a member of the Consulting Services Advisory Council of a major investment firm. Here, we set policy and discussed how to develop an optimal investment strategy for each client. I traveled in my off hours to other regions of the country where I spoke with advisors about the proper role of money managers. Many brokers began to incorporate the use of private money managers into their business in order to work less. At the same time, the very best consultants were putting in long days meeting with clients to discuss how to improve their results. It wasn’t perfect, but if managed professionally, it was a huge improvement over the days when a stockbroker called you with a ‘hot stock.’
Cracks in the System
In 1998, we began to see the first cracks in the system. They appeared when our advisory council studied what we called ‘style creep.’ This was a term used to define any manager who did not stay within their area of expertise and began to deviate into areas that they did not fully understand. An example would be a money manager who specializes in out of favor companies suddenly deciding to buy technology stocks at 40 times earnings! This trend began to dangerously undermine a system originally designed to add value for the client.
The Advent of Market Indices
Money Managers and Mutual funds have always compared their performance to a benchmark. A benchmark is an index made up of investments similar to the ones owned by the managers. In the mid 1990’s, low cost market indices were offered for the first time. Mutual funds and money managers had some real competition. In addition, brokerage firms began to allow the limited use of a flat fee instead of commissions. Once the number of indices grew larger and the fees became less than those charged by money managers there was no longer any reason to use wrap fee programs. The key here is that roughly 80% of all professional managers under perform the indices they are comparing themselves to. That means that you only have a one in five chance of beating the market. Market Indices offer a combination of lower fees, diversification, and the ability to control the amount of cash you have in the market. For these reasons, market indices represent an ideal investment option in the equity markets. Lakeside has been at the forefront of index investing since 1999 and continues to be a strong proponent of this investment philosophy.
For a more in-depth look behind the scenes you can also read the follow up article below.
In the 1970’s brokerage firms were looking for ways to create more consistency in their profits. They also could see that highly sophisticated investors who had more than $5 million to invest were likely using private money managers. The brokerage firms went to these managers and proposed that if they were to allow them to offer their services to clients with substantially less to invest, the brokerage firms would in turn take care of all administrative and clerical work. They both benefited. The money managers would receive in aggregate a large sum to invest and the brokerage firms would parcel that large sum out to many clients with as little as $100,000 to invest. Since the total amount was very large, both manager and broker could all receive a portion of the fee. The fee structure looked something like this:
Over time, these fees have come down. However, they are still high compared to our .50%-1% base fee for investment management, access to real estate opportunities, performance reports and review meetings.
The real risk with these programs comes from the manner in which they are employed. Stock brokers are in the business of gathering assets as opposed to making clients money. For this reason, stockbrokers tend to recommend the “hot manager” in the same way they used to recommend the hot stock. This usually occurs right after the manager has performed well and right before they perform poorly. This inherent conflict of interest has consistently posed problems within the money management business. At Lakeside, we take an alternative approach. We are committed to providing the investor with comprehensive, unbiased financial services. Our proprietary solution to the wrap fee dilemma is available only to our valued clients.
What if you went to buy a portfolio of stocks and all the best ones were taken? This is a very real possibility that may already be negatively affecting performance for the average investor.
In 2005, private equity firms acquired more than 1,115 publicly traded companies for roughly $400 billion. In 2006, the number was even higher. In 2007, the number looks to be greater than the past three years combined. Private equity firms have very specific goals: buy solid companies at a fair price, run them better than before and sell them at a premium in the future.
Here are the names of some of the companies that can no longer be publicly invested in:
Dunkin Donuts, Hertz, Toys R Us, Neiman Marcus, Hospital Corporation of America, Clear Channel Communications, Caesar’s palace, Cadbury Schweppes, Celanese, Center Parcs UK, CineWorld, Deutsche Telekom, Extended Stay America, FGIC, Freedom Communications, Freescale Semiconductor, Graham Packaging, HealthMarkets, Houghton Mifflin, Michaels Stores, Nalco, The Nielsen Company, Orangina, Southern Cross/NHP, SunGard, Texas Genco Holdings, Travelport, TRW Automotive, TDC, Universal Orlando, Ushodaya Enterprises, Vanguard Health Systems, and VNU, Equity Office properties, AllTel and Chrysler.
The reason this is important to you is simple.
As quality companies are removed from the public marketplace, there remain progressively fewer attractive equity positions for the common investor.
After Chrysler was purchased by Daimler-Benz for $38 billion, it experienced a significant drop in value. Traditionally, one could then buy shares in the company for a reduced price. Instead, it was a private equity firm (Cerberus) that purchased Chrysler for $7 billion with the prospect of large future rewards.
When stock prices fall, savvy investors often acquire shares cheaply, recognizing profit potential in the long term. These opportunities are gradually slipping away as the very best companies are taken private.
Our solution at Lakeside Capital resolves this dilemma in a manner that mutual funds, brokers and money managers cannot. To hear more about our proprietary solution to The Disappearing Stock Market contact any one of your trusted Lakeside Principals.
This is typically a good time of year to reflect on risk tolerance, liquidity, cash needs, and debt load. As such, we have been carefully liquidating specific stock positions for our family accounts over the last week. Our interest is in protecting your net worth by lowering your risk to the stock market. We accomplish this by moving assets away from equity markets into other asset classes. In some cases, that asset choice is cash.
With this in mind, we encourage you to ask yourself the following questions:
Taking a few minutes to reflect on these questions will help you make better decisions about your tolerance for risk and create better security for your family. Better decisions today means less regret tomorrow.
We thank you for the confidence you have placed in us as we help you protect and strengthen your net worth. Please do not hesitate to share with us any concerns or needs you have now or in the coming months.
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