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The Quarterly Report

  • The Quarterly Report
  • First Quarter 2012
  • Chuck Osborne

Mr. Smith Goes to Wall Street.

Can you tell us how you really feel about your former employer, Mr. Smith? For those who may have missed it, Greg Smith was an employee at Goldman Sachs until this past March when he resigned and had his stinging resignation letter published in The New York Times. He claimed that Goldman Sachs has become a toxic environment where the firm thinks only about its own profits and cares little for its clients. He relayed stories in which senior-level executives referred to clients as “muppets” and the most common question asked about an investment is, “How much money did we make off the client?”

His letter quickly went viral, posted and shared throughout the internet and various social media sites. If his fifteen minutes of fame was what Smith had in mind he succeeded, perhaps at the cost of his career. His letter was one-sided and perhaps a bit extreme, but it did sound very familiar to me.

I saw similar things in my previous career, which motivated me to start Iron Capital. Too many people see stories like this and go immediately to the easy conclusion that “those people are just greedy,” or “they are bad people.” That is too simple, and not realistic. The problem is much bigger, and it is about the entire structure of Wall Street. Interestingly, Jamie Dimon of JP Morgan commanded his people not to take advantage of Mr. Smith’s story. Perhaps he was just taking the high road, but it seems more likely to me that he understood that that letter could have easily been written by one of his employees, or by anyone from any other Wall Street firm.

The problem with Wall Street today boils down to the simple truth that one cannot serve two masters. I started my investment career 20 years ago, and back then stock brokers were stock brokers. They were drilled on the fact that they could not and would not provide advice. They could guide their customers, just like any good sales clerk, but they absolutely did not provide advice. Today, just 20 years later, they call themselves financial advisers. Smith is pointing out the problem with this dual identity. He even states in his letter that he had “the privilege of advising two of the largest hedge funds on the planet.” I am sure he really believes this, but that is complete nonsense. The two largest hedge funds on the planet are not seeking the investment advice of a mid-level derivatives broker at Goldman Sachs. They may buy derivatives from him, but they are doing their own research and when they pick up the phone to call a Wall Street firm they are looking for someone to fulfill an order. They want a broker, not an adviser.

This is the conflict that Smith has going through his mind. He is trying to reconcile his job as a seller of a product with his self image of being an adviser, and he can’t do it. He can’t do it at Goldman and he won’t be able to do it anywhere else, because it cannot be done. One simply cannot serve two masters: one cannot ethically be on both sides of the table.

We have been preaching this message since our founding in 2003, but I think it is hard for many people to fully underWe have been preaching this message since our founding in 2003, but I think it is hard for many people to fully understand. In a relatively short period of time Wall Street and its marketing machine have convinced a generation that they are there to give advice, which is a huge conflict of interest and a fundamental flaw in the business model.

In 2004 the SEC and the Department of Labor (DOL) teamed up to investigate the advice given to retirement plans. They came out with a list of ten questions that retirement plan sponsors should ask their advisers to ensure that they were receiving objective advice. We use this list in our institutional business, and in reading Smith’s letter I realized that it would be good to share it with private clients as well. After all, a large retirement plan may be more complicated, but fundamentally it is still just an investor seeking investment advice. If the SEC and DOL guidance is good for retirement plan sponsors, it should be good for individual investors as well. Here are the questions:

1. Are you registered with the SEC or a state securities regulator as an investment adviser? If so, have you provided me with all the disclosures required under those laws (including Part II of Form ADV)?
Note that they do not ask if you are registered or “licensed” with a brokerdealer, which is the bad advice often given to individuals. In the investment world we often use the terms buy-side and sell-side. The sell-side is what most think of as Wall Street – they create and sell products. The buy-side is the investors and fiduciaries acting on behalf of investors. Traditionally, sell-side firms are registered as broker-dealers and their employees as representatives of the broker-dealer. Buy-side firms register with the SEC as investment advisers.

Objective advice is a buy-side function. Unfortunately this line has blurred as many firms have become dually registered. That simply sounds confusing to most people, but if instead of saying dually registered one used plain English and said they represent both the buyer and the seller, the conflict of interest becomes clearer.

2. Do you or a related company have relationships with money managers that you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, describe those relationships?
Immediately they ask about conflicts of interest. One cannot give objective advice while being paid by the product they are selling.

3. Do you or a related company receive any payments from money managers you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, what is the extent of these payments in relation to your other income (revenue)?
Here they basically repeat the last question in a slightly different manner, emphasizing the importance of independence.

4. Do you have any policies or procedures to address conflicts of interest or to prevent these payments or relationships from being considered when you provide advice to your clients?
We do not believe conflicts can be overcome, but because the vast majority of firms do have serious conflicts woven into their very business models, this question has to be asked.

5. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, do you monitor the amount of commissions paid and alert plans when consulting fees have been paid in full? If not, how can a plan make sure it does not over-pay its consulting fees?
This question may not sound relevant to individuals, however: If you are paying your adviser through commissions, how do you know how much you have paid?

6. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, what steps do you take to ensure that the plan receives best execution for its securities trades?
If you are getting advice from a traditional broker, the expenses you pay are actually revenue to them and to their firm. There is no way you are getting best execution.

7. Do you have any arrangements with broker-dealers under which you or a related company will benefit if money managers place trades for their clients with such broker-dealers?
This is huge for individual investors. A critical point: The SEC and DOL are suggesting that investors should be leery of anyone that has any “arrangement” with a broker-dealer. Again, a broker-dealer is the sell-side, or what one might think of as a Wall Street firm; Goldman Sachs, Merrill Lynch, Morgan Stanley, Charles Schwab, and E-trade are all brokerdealers. They are the firms that custody assets, sell products and execute trades on behalf of their customers. This is exactly where the vast majority of individual investors get their “advice,” and the SEC and DOL are telling institutional investors that they should be concerned if there is any business connection, let alone the adviser being an actual employee of the broker-dealer.

I have been preaching this message for years. I think some of our clients and readers get it, but others probably just hear this as me promoting our business model. This is not coming from me; it comes from two government agencies tasked with protecting retirement plan investors, and the implication is clear: Do not take advice from an employee of a broker-dealer.

8. If you are hired, will you acknowledge in writing that you have a fiduciary obligation as an investment adviser to the plan while providing the consulting services we are seeking?
Broker-dealers and their employees do not have a fiduciary responsibility to their customers. This does not mean that they have no responsibility. Like any merchant selling a product, they should stand by their product and they should not sell anything that is not suitable. But, being a fiduciary is a much higher standard.

9. Do you consider yourself a fiduciary under ERISA with respect to the recommendations you provide the plan?
The highest standard for fiduciaries is provided by the Employee Retirement Income Security Act (ERISA). Under ERISA a fiduciary must act solely in the interest of the plan and plan participants. When we started Iron Capital we were among a very small group that accepted this level of responsibility; today I am glad to say that we have many more competitors. Some have been dragged kicking and screaming by client demands, but several firms share our belief that this is the way an advisory firm should operate.

10. What percentage of your plan clients utilize money managers, investment funds, brokerage services or other service providers from whom you receive fees?
I can’t say it enough: One cannot serve two masters. When you are getting paid to sell a product you are not able to also provide objective advice, period.

That does not mean that salespeople are bad people. They are by nature competitive people. They want to win, and winning means selling the customer their product. When the customer does not cooperate they may get frustrated and say things in the privacy of their offices out of emotion, such as calling a customer a “muppet.” They are and always have been rewarded by their employer by bringing in revenue. They legitimately want to know how much money the firm made from their sales efforts. There is nothing wrong with this. We expect this from a salesperson. I’m sure the clerk at Brooks Brothers thinks I am crazy for not liking the ties he suggests. We all laugh when Julia Roberts, in the famous scene from “Pretty Woman,” goes into the store that had refused to help her the day before with her arms full of packages and asks if the clerk works on commission. Holding out her packages she says, “Big mistake. Big. Huge!”

There is nothing wrong with being a salesperson, as long as one is honest about it. The problem with Wall Street today is that its salespeople have been convinced through training and marketing spin that they are, in fact, advisers. Smith’s letter is the result of this identity conflict. He believes that he was supposed to be a trusted adviser, but he lived in a sales culture.

Many investors today believe they are working with a trusted adviser, but in reality are simply buying products from a nice salesperson. This may be what one wants. Brokers did very well before the culture of Wall Street started to deceive people about their role. However, if advice is what you seek, then take some from the SEC and DOL and ask your adviser the ten questions. You may be surprised about what you learn.


Charles E. Osborne, CFA, Managing Director


Review of Economy

The pattern continues. We get some good economic news, expectations rise, then the news does not meet expectation, then expectations fall. In the first quarter we got mostly good news and expectations have risen. Don’t be surprised if reality disappoints. The economy is continuing its slow slog at right around 2% growth and that is what we expect for 2012.

Unemployment has gotten better with the rate dropping to 8.3%. It will be interesting to see if these end up being permanent gains or just a seasonal blip. We are hoping for the former but we have seen false starts before. The real issue for 2012 remains Europe, but now concerns about China have been added to the mix. The question is, can we grow if the rest of the world does not?

Review of Market

The S&P 500 soared during the 1st quarter and ended up 12.59%. Is this rally for real or is this the prelude to a repeat of 2010 and 2011 when good early starts were undone by summer downturns? Unfortunately, we believe it may be the later. Small caps did well but could not quit keep up the pace, with the Russell 2000 up 12.44%. The good news is that underneath the broad market indices relative performance seemed to make more since and fundamentals once again seem to matter.

Bonds were relatively flat for the quarter with the Barclays U.S. Aggregate index up only 0.30%. The fear of European collapse was calmed by the actions of the European Central Bank and we saw U.S. yield drift slightly upward.

International markets continue to be the worst place to be, even in this positive atmosphere. The MSCI EAFE was up 10.98% for the quarter. We believe international markets will continue to underperform in both up and down markets as the crisis may have been averted but the medicine is likely to cause a severe recession.

Market Forecast

Our outlook remains negative. In fact the rally in the first quarter has only made us more concerned about a potential shock. In the midst of the rally we saw one day when markets worldwide were down almost 3%. That selloff was started by a rumor that a pipeline in the Middle East had been set on fire. If we see this reaction to an unsubstantiated rumor, what will happen if these risks truly materialize? Our best prediction continues to be that the markets end the year flat with more extreme volatility. In other words we see a correction coming.

U.S. large cap stocks remain the most attractive asset for the long term. We still like large dividend-paying stocks.

Bonds look troubling over the long haul but will likely remain a safe haven during times of crisis. Commodities will depend greatly on oil and the tensions in the Middle East.

The biggest risk to our outlook is that Europe does somehow muddle through without a big incident. In that case, we would rather risk making less in an up market than losing more in a down market.