"Competition is a sin."
--Attributed to John D. Rockefeller
One of the greatest monopoly stories in US history is that of the American railroad.
During the nineteenth and twentieth centuries, railroad barons quickly established a distribution network that revolutionized transportation. The railroad operators monopolized the transport of goods and services, passing along high rents to the American consumer, reaping enormous profits along the way.
Today's railroad monopoly is the banking system. Leveraging their distribution networks to sell proprietary financial services, banks reap tremendous profits, usually at the expense of their clients. In a competitive market, poor client outcomes would force banks to change their behavior. And at the margin, firms such as Vanguard, Interactive Brokers, and a flood of fee-only independent advisors, have chipped away at the banks' "railroad". However, banks, and their powerful distribution capabilities, have managed to limit the competition's advance. They continue to push high-fee, tax-inefficient, opaque, non-client-friendly products into the financial services marketplace. Competition is certainly changing the market for the better, but there is an overwhelming majority of investors that remain unaware of the bank railroad and its expensive consequences.
Open Architecture Defends Against Railroad Baron Bankers
Only a few short years ago, most banks were "closed architecture," meaning they only offered their own investment products to clients. Instead of wearing different hats,financial advisors and product salesman were the same person. While the client wanted to maximize after-tax, after-fee, risk-adjusted returns, the advisor/broker wanted to maximize his personal profits. Not surprisingly, year end bonuses trumped client needs, and billions of dollars in expensive, tax-ineffiecient products burrowed their way into client portfolios.
Naturally, clients got upset. Imagine John Q. Investor, having saved for decades, finally retiring and purchasing his dream sailboat. Pulling into port to christen the SS Frugal, he looks astern to see his financial advisor steering a new, luxury yacht. And that was the scenario that played out between banks and their clients for years. Customer got dinghys. Advisors got yachts.
Angry clients began to push back. Fearing mass defections, banks and their associated advisors/brokers ("brokers"), capitulated and expanded their product offering to include non-proprietary products. Now the playing field was level and every product was available to clients. The golden era of "Open Architecture" was upon us and the client / bank relationship entered a new era of peace and prosperity, right? Not so fast.
Here is a Barron’s article from a few years ago discussing the open architecture concept:
…the big wealth-management outfits have reluctantly been building out "open architecture" platforms, the trade term for offering a wide range of investment products run by outside managers.
All Aboard the BS Express! Destination: Your Retirement Account.
Banks make billions by selling their own asset management products. They sell directly to clients (e.g., individuals with a retirement account) and via advisors/brokers in their network (e.g. local investment advisor backed by a big bank brand). Bank's clients/advisors are only allowed to buy "approved" products. Of course, the bank owns the "approval" process and determines what is allowed to get on their platform and what is kicked to the curb.
Of course, some filtering should be done to prevent fraudulent products and outright scams. One only needs to watch three minutes of Wolf of Wall Street to see why quality control is necessary (sidenote: do NOT watch Wolf of Wall Street with your parents...very awkward).
However, there is a clear opportunity for banks to manage their approval process and skew approvals toward products that reward the bank. Does the product generate lots of fees? If yes, chances are the product will be approved before a low-fee, external alternative. If customers demand a low-fee external product, why not slap an "access fee" on the top to recoup the revenue? If you need an example of this practice, kindly Google (GOOG) "Kickback scheme" or chat with your local Washington DC lobbyist.
But What About the Client?
These "approved" products may not be the best option. In fact, such products are almost never the best option because of--drumroll please--higher expenses. Herein lies the conflict of interest: banks want to maximize profits, but clients want to maximize after-cost risk-adjusted performance.
Here is a quick example. Consider a client that walks into "MegaBank" looking to invest for retirement. The client asks the MegaBank advisor about their options:
- Buy MegaBank's US Large Cap Equity Mutual Fund at a 1.5% management fee.
- Buy a sponsored product, which has a hidden 0.50% kickback fee to MegaBank.
- Buy a 0.05% Index Fund and the bank makes a $10 commission.
From Megabank's perspective, option 1 can pay thousands of dollars, option 2 can pay thousands of dollars, and option 3 will barely pay for the rep's double mocha soy latte after the client meeting.
What option do you think Megabank "advisor" will recommend?
How do Big Banks Deal with the Open Architecture Dilemma?
The banks' dilemma is getting worse. The conflict of interest mentioned above has been highlighted in the mainstream media, and key outlets smell blood in the water. For example, JP Morgan Chase & Co. (JPM) has been embroiled in some controversy over this issue over the last few years, as detailed here and here.
Some banks have sought to address this conflict of interest head on and alter their fee structures. Other banks have sold off their mutual fund complexes entirely. Consider Barclays PLC (BCS) - A recent Barron’s article has a quote from Barclays, which, according the article, has eliminated internal products and embraced open architecture:
"We are completely on the same side of the table as the client because we don't have to support an internal asset-management business," says David Romhilt, head of manager selection at Barclays.
Wow...did Barclay's really just sell off a tremendously profitable business division to "be on the same side of the table" as their clients? Should we believe that a large bank would willingly open up the railroad tracks so that others may travel freely?
Of course not.
Let’s dig a little deeper into Barclay's clever move and the hidden economics of distribution.
Makin' it Rain in an Open Architecture World
Any economics student can tell you that owning the railroad is what makes money, not the railcars. The same lesson applies to our Barclay's example - selling their own product doesn't matter because they own the tracks! And the beauty of owning the rail tracks is you get to charge other railcar operators a fee for riding on your network. Eureka!
Banks are skilled at charging fees to railcar owners (i.e., outside investment managers) that want to ride on their tracks. But the payment isn't always direct--that would be tootransparent and clients might get mad. Years ago, one way that banks and their brokers derived profits from external products was via “directed brokerage.” Under directed brokerage, a bank/broker would enter into a fee for service arrangement with a mutual fund. The bank would promote the fund to their clients, and in return, the fund would channel trading/execution orders to the bank. Bank/brokers get extra commission revenue and the fund managers get access to customers. The only loser in this arrangement is the client, who gets stuck with extra fees (and oftentimes, they aren't even aware of them).
Thankfully, the SEC made this practice illegal in 2004, but the ink wasn't even dry on the rules before alternative kickback schemes arose. Here is a WSJ article discussing the ban:
Still, the crackdown on what is known as "directed brokerage" isn't likely to alter the underlying environment in which hundreds of fund companies, all competing for "shelf space" at the brokerage firms favored by individual investors, feel obliged to pay for that access in one way or another. "If they can't pay through directed brokerage, then they will pay another way," predicts Cynthia Mayer, a fund-industry analyst at Merrill Lynch.
Shelf space. Railroad access. It's all the same. Funds pay, banks get a fee, and the client funds the journey...but it gets worse.
The WSJ article above goes on to discuss the rise of “revenue sharing,” which is the model that prevails today. Under a revenue sharing arrangement, instead of directing trades to the bank, the fund agrees to share a portion of its management fees with the bank. The bank maintains profits by awarding scarce "shelf space," and the fund gets distribution on the bank platform. Generate a lot of fees for the bank? Earn more shelf space! Don't worry, you may knock some cartons of good product off the shelves, but that's ok, because the bank is getting paid!
Revenue Sharing Junction: What's your Function?
Let’s say you’re a financial advisor/broker associated with Megabank. You want to recommend a product to your client and you are choosing between 3 advisor strategies, with the following characteristics (assume similar risk across all three options).
Note that Advisor C, is clearly best for the client: higher gross expected returns and lower fees!
Now let’s look at things from the bank’s perspective.
The bank has gone out and negotiated a revenue share with each of the 3 Advisors, as follows:
From the bank's perspective, advisor A is clearly the best: the higher fee products maximize the bank's profits, even with the lowest profit-sharing percentage. High fees rule the day: A bad deal for clients, but hey, on Wall Street, "two-out-of-three ain't bad."
Note that Advisor C has offered the bank a full 90% of its fee, and it still cannot compete for the bank's favor. There is simply no way for Advisor C to match the bank's profitability derived from the inferior advisors.
So what will the railroad track owner (i.e. bank), do?
The easy answer is to block Advisor C railcar from getting on the tracks. But there is a problem: the client has heard about open architecture and wants the cheaper, tax-efficient railcar. How can the bank quietly prevent customers from demanding product C? Why not place product A on a preferred list of securities with more research and snazzier reports? Or maybe make the client sign a really scary waiver in order to purchase product C? Better yet, make everything manual and require paper copies to slow things down. Perhaps we create an "approval" process that fastracks profitable products and buries the least profitable products in an administrative black hole with no chance of escape?
Think these are made up examples? Independent, affordable, and client-friendly investment products hit the bank brick wall every time they enter a bank boardroom. Bankers aren't stupid--they own all the yachts for a reason! And the last thing a banker will do is invite competition in via the front door, without a quid pro quo that ensures they can somehow make money off their clients.
At our own firm, Alpha Architects, we recently met with one of the largest banks on the planet--that shall remain nameless--and we had a conversation with one of their top private bankers. Frankly speaking, a good guy - super friendly, successful, smart, and so forth. A perfect relationship guy to manage client needs. We discussed various products we offered that had compelling value propositions. The private banker loved our pitch, and responded as follows: "Yeah, that’s certainly a unique and high-quality product, and I'm sure we could do some kind of revenue share with your stuff, but honestly, I can’t see how my guys can get paid selling it. You don't have enough juice in your fees.”
Not enough juice in our fees?
We felt like we were trapped in a Michael Lewis novel, but it made perfect sense. As the example above highlights, lower fee products do not produce enough income for a bank. From the bank's perspective, the quality of a product is secondary to its profitability.
So let's summarize the new, "cleaner" open architecture model that involves divesting the bank's in-house investment management unit:
- Deny shelf space to lower margin products. Check.
- Limit client options to high fee products. Check.
- Generate lots of bank profit. Check.
- Keep the peace with clients and branded advisors by promising "robust due diligence" on client-demanded products. Be sure to maintain steps 1-3. Check.
Ladies and gentlemen, welcome to the bank distribution game, the railroad monopoly for the 21st century.
And What if Asset Managers Get Smart?
Conflicted bank/broker incentives are not limited to eliminating lower-cost products from the bank's platform. Consider a story we heard about a large mutual fund complex who was listed on a bank platform for many years, paying enormous "railcar" fees to the track owner. Over time, the funds did well, giving the mutual fund complex increased bargaining power versus the bank, who got a lower and lower percentage of the funds' fees. Eventually, the funds demanded so much of their own fee, thus eroding so much of the bank's profit, that the banks concluded they didn't want to offer products from the platform any more (i.e., they couldn't get paid), and the funds were kicked off the platform. There were more expensive, more profitable funds the bank could put on the tracks. The high-performance railcar was causing them too many problems.
"Remarkable!" you might say. Well, after dissecting the economics of bank distribution, this is a no-brainer. Boot the low-profit railcars from the track and finder a high-profit railcar!
But Aren't the Banks Being Short-Sighted?
A general equilibrium economist might question the bank's rational decision-making process. Monopolies don't last forever. On one hand, maximizing profits via the exploitation of distribution economics is rational in the short-run. However, the banks must consider the fact they operate in a dynamic marketplace. Enlightened clients and independent asset managers are finding ways to avoid the bank distribution channel (e.g., ditch railroads and fly on airplanes). And if no clients are in the bank distribution channel, the distribution channel is worthless--there are no clients to exploit!
An economist may look at the bank's reluctance to adapt to the current, more competitive environment, as "short-sighted," but status-quo bias, bureaucracy, regulation, and "head-in-the-sand syndrome" affect even the best institutions. Nonetheless, the long run-game is clear: the bank railroad is under attack from multiple angles, and pitchfork bearing investors won't be satisfied until full transparency reigns (see Indexing 2.0). Technology, client education, the rise of independent investment advisors, and direct-to-consumer marketing efforts on behalf of asset managers are eliminating the need for a middleman. The bank's railroad is slowly becoming a relic of the past and yachts are starting to sink.
Don't Get Railroaded by Your Financial Advisor
The simple matter is that most clients know how to buy groceries, but few know how to purchase financial products. In the murky world of financial services, clients may be buying products for the first time. More importantly, this purchase is the driver of their long-term financial security. Years of hard work, thrift, and responsible life choices, are baked into each and every retirement portfolio that a banker must now serve. In short, the stakes are too high and the cards are stacked too favorably towards one party. Fiduciary responsibility matters in financial services more than in any other product category outside of urgent medical care. Shouldn't this fiduciary have your best interests at heart?
Moral of the story: Ask your banker, or bank-affiliated advisor these questions. If you get answers that sound like the ones above, it might be time to buy a car or an airline ticket, because traveling via railroad is a thing of the past.
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