FRC report: Merrill Lynch, Morgan Stanley, UBS, Wells Fargo are undergoing a radical transformation to a brighter future
Their power to bring institutional-level investing to mass affluent investors could give them the edge though observers have doubts
Brooke’s Note: This article is based on a study that has a theory about how wirehouses can regain their edge on RIAs. In the world of stocks, when everybody knows something, it often turns out to be wrong. That’s one reason I found the contrarian view contained in the study to be very interesting.
The upheaval in the wirehouse world may lead to a surprisingly bright future for a business model that many people had said was past its prime, concludes a new report by the Financial Research Corporation of Boston.
“Conventional thinking has been bearish on the wirehouse industry, since they have been battered by bankruptcies and bailouts,” said Robert Martorana, author of the FRC’s 145-page study, Re-Evaluating the Wirehouse Opportunity: Gatekeeper, Asset Manager, and Advisor Insights. “But the outlook is brightening, as the wirehouses are reinventing their advisor strategies and portfolio construction to gain a bigger slice of the wealth management business.”
A series of interviews with wirehouse gatekeepers led him to conclude that the firms are committed to the open architecture model that many see as the future of the business. Gatekeepers are the wirehouse executives charged with deciding what products can or cannot be sold by the staff.
He also said the firms’ ability to invest in research to create institutional-style strategies is a long-term advantage.
A few advisory experts took issue with the study’s conclusions, especially on the idea that wirehouses can create better investing strategies that could be made available to the wealthy and mass affluent investors that wirehouses and independent advisors are fighting over.
An endowment model succeeds by drawing on at least 20 top money managed across all classes of assets, pointed out Jeff Spears, CEO of Sanctuary Wealth Services in California. But most of the top managers aren’t interested in dealing with the small minimums needed to serve the mass affluent.
“If anybody could effect that, it’s the wirehouses with their buying power but I don’t believe any of the managers used by the Harvard and Yale endowment model are going to agree to play. You’re cutting it up into slices and the type of manager that raises their hand is more interested in asset gathering than alpha (i.e. beating the market averages).”
FRC declined to allow RIABiz to see the contents of the 145-page study but sent a brief summary of the points in a release, and allowed an interview of the author, Robert Martorana, former head of equity research for Barclays Global Investors.
FRC writes its studies independently and sells them as trade research to companies in the industry.
Martorana countered that wirehouses are taking a reasonable approach to getting more managers onto their platforms — especially in area like small cap where managers tend not to manage large pools.
“For capacity-constrained portions of the market, they all had lower minimums that they’d look at but they can’t do due diligence on everything.”
Wirehouses have been battered by a long-term trend and a crisis. The former was the loss of market share to regional brokers, independent broker-dealers and registered investment advisors (RIAs). The latter was, of course, the credit crisis of 2008-09. Many people have counted the wirehouse model out as the company brands took a hit and there was an uptick of breakaway brokers that had an air of permanence.
But the companies — Bank of America, UBS, Wells Fargo and Morgan Stanley – have now set about changing the way they work with investors, advisors and asset managers, the study says. They may well be successful.
All four wirehouses precluded Martorana from conducting even a single interview of a financial advisor but allowed him generous access to “gatekeepers.” The wirehouse firms control $4.6 trillion in assets under management.
“It’s a big mistake to underestimate the wirehouses,” said Martorana. “They have strong brands, wide access to product providers, and substantial resources for investment research. As these firms reconfigure their value propositions, they are going to surprise product providers with their ability to gather assets.”
There is one aspect to Martorana’s argument that is undeniable, according to Spears.
“(PriceMetrix, a (Toronto-based) service that tracks client investing activity) shows that the only area where wirehouses are gaining is in fee-based accounts. It’s a reality. The difference is with the specifics around account size. It’s a little above $250,000. It’s not at the RIA level (of assets).” RIAs frequently will not accept accounts that fail to meet a $1 million minimum.
What Martorana took away from the gatekeepers on a high level is that they are sincere and ambitious about eradicating one charge that’s consistently leveled against them – that they don’t have open architecture. “They’re committed to open architecture; they’ll be very different in a couple of years.”
Spears said the study may be hampered by the restriction to gatekeepers who he says have traditionally not been the movers and shakers on the Wall Street brokerage scene.
“The people in the wrap consulting group are junior people; they have a lot going for them but they’re not a lot better than a check-the-box type of due diligence.”
Martorana said that wirehouse brokers — with help from these gatekeepers — can deliver the gold standard of institutional investment management known as the endowment model. Made famous by Yale University in particular, it is marked by use of an admixture of alternative investments, products to hedge tail risk (like options), risk analysis, correlation analysis, active and passive products and tactical (i.e. trading of commodities and the like) and strategic (i.e. longer-term and diverified) approaches. See: The Yale endowment model of investing is not dead
RIAs as dabblers
“I don’t know many (independent) advisors who (make use of the endowment model)”, he says. “A lot of financial advisors are dabbling ( in serious investment processes and products) and the wirehouses want nothing to do with that (dabbling).”
To support his argument, Martorana points to an FRC survey of 700 advisors completed in 2010 showing that 84% of wirehouse advisors use alternative investments versus just 60% across all channels.
Spears took issue with that, saying that most RIAs can hardly be considered dabblers.
“That’s the RIA that existed 10-15 years ago with the CFP. The RIA has gotten a lot more investment savvy over the last three years – almost by necessity.”
Asset custodians are working to make it easier for RIAs to use See: Schwab leads effort to create industrywide solution for alternative assets.
Tim Welsh, president of Nexus Strategy, who formerly worked for Merrill Lynch and still has a close friend working for a wirehouse, says he has seen little evidence that these brokers are introducing an endowment-style model to clients – or why they would want to.
“Why do you want to bring something complex to the mass affluent? We’ve seen tremendous problems with alternative investments.
Martorana argues that it is the wirehouses that have the resources to spend on the expensive process of vetting investment managers and alternative investments.
Where to find manager research
One frustration that Martorana expressed about his study was his inability to see how the delivery of open architecture — however well-intentioned at the gatekeeper level at the wirehouses — was affected downstream by sales incentives at the branch level. He would have needed better access to advisors to ascertain that. The wirehouses denied him that.
Two advisors who left wirehouses because they felt a degree of discomfort with that subtle pressure were written about in these articles. See: Why one Wells Fargo defector had no use for wirehouses, IBDs or the RIA model and See: Why one Merrill Lynch advisor needed to break away twice to become an RIA.
He sees a big potential downside with cross-selling of bank products – particularly by Bank of America/Merrill and Wells Fargo. It has the sales-y veneer of a McDonald’s counter-person shaking you down for a side order of french fries with your hamburger.
“They made it clear that cross-selling is important to them. The negative side — it’s like: do you want fries with that?”
The wirehouse model model is crippled in several important ways that preclude it from being competivive with the RIA model.
1. The broker has no onging responsibility for recommendations once they are made and executed and the broker is paid precluding the ongoing fiduciary duty of care and loyalty. Structurally the industry is not prepared to support of be accountable for the advice rendered by its brokers as fiduciary liability is triggered and the industry insists that any advice rendered is incidental to trade execution services provided.
2. By focusing on product due dilligence/gate keepers, the industry’s emphasis is on selling investment products or hot performance dots not addressing and managing investment and administrative values on an ongoing basis, on behalf of the consumer in their best interests.
3. The overarching totally customized investment strategy for each individual client is not supported technologically by the brokerage industry so a recommendation can be made in the context of all the client’s holdings, only then is it possible for the industry determine whether a recommendation improved overall portfolio returns, reduced risk or contributed to the tax efficiency, liquidity, cost structure, etc or the clients holding as a whole.
4. Conflicts of interest like treating trade execution as a profit center rather than a cost center precludes brokers from fiduciary standing. Brokers simply disclose conflicts which perpetuates the conflict which will not allow the best interest of the consumer to be served.
5. The brokerage industry has not created a CIO function for brokers which supports the management of an unliited number of investment and administrative values for an unlimiuted number of totally custom client accounts, which requires (a) a structured authenticated audited prudent investment process required for fiduciary standing, (b) advanced technology, (c)overlay management to manage complex values like tax efficiency, trade execution cost, etc, (d) access to real time buy/sell research and an overarching strategy function built around each client’s investment policy and (e) assumption of responsibility for every recommendation made and every client holding monitored.
Investment research gate keeping is a small fraction of the consideration and there is no factual support for middle managers having any influence over the direction of the industry. Leadership must start at the top.
The insular nature of wirehouses does not allow them to presently be responsibe for protecting the best interests of either the broker or the consumer as the needed innovation is necessarily is deemed highly disruptive and too complex to manage. One of the giant b/ds has less than 20 brokers who are allowed to create legitimate investment policy statements essential for fiduciary standing. So, there is a very long way to go.
The retooling of the industry is indeed required, as envisioned by almost everyone who has following regulatory reform—the question is one of vision, leadership and the latitude to execute—which is in short supply. Harvard’s Clayton Christensen (“Innovators Dilemma”) observes, the biggest mistake industry’s face in industry innovation, is to look at innovation in the context of the existing business model when a new business model is in order. Incremental solutions add to complexity, while comprehensive solutions simplify. In order to simplify,the industry must go far above middle management for a solution. So far, top management is not engaged at any of the major firms, there have been no retolling efforts, and without top management engagement RIAs have a massive edge in execution.