Most Local Advisors Can’t Compete

I used to work for a bank-owned advisory firm which competed with the mutual fund behemoths of the world. While we had decent performance during my tenure there, a depressing reality haunted me because I knew that in the long run there was no way that we could compete effectively with our mutual fund competitors.

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We were a small trust department. When I joined the shop, we had 1,800 clients and about $300 million invested in our trust department common trust funds (which are like mutual funds except that they can only be used by internal trust department clients). We managed three stock funds and four bond funds. When I arrived in at this shop in 1995, the bank's long-term investment record was pretty sad. During the previous five-year period, while stocks generally were increasing 15% a year, the bank’s stock portfolios were appreciating at a 10% clip. While some investors were pleased by double-digit returns, more knowledgeable investors were beating us up (and closing their accounts) because of our underperformance relative to the broad market. By the time I got there, only "brain dead" clients, who didn't know enough about investing to know that they should fire us, remained.

We junked our existing stock selection process which picked stocks by committee. Instead, a single portfolio manager was assigned to manage our stock portfolios, and another portfolio manager was picked to manage most of our bond funds. Portfolio managers were given authority and accountability for their decisions. The frightening part was that these fund managers had no staff support, inadequate technology, and no analytical support. Moreover, these individuals were also assigned various other duties. Our bond fund manager also coordinated mutual fund company relationships. Our equity manager also traveled throughout the Ozarks to meet with clients and prospects and was also required to participate in various administrative meetings. He had no analysts researching investment alternatives. Because of his other duties, he was not even a full-time portfolio manager although we did the best we could to protect him from the bank's substantial bureaucracy.

Contrast this structure with that of a good mutual fund company. The mutual fund company has several analysts who usually specialize by industry. These analysts research individual companies. The analysts read the financial press, have access to the research of numerous Wall Street brokerage houses, and read the industry trade journals as well. A large fund company will have little problem getting access to senior management at a company. Frequently company management, and Wall Street analysts, will travel to the fund company's offices for presentations. Analysts have the freedom to travel to industry conferences, call on customers and visit company sites. They research that firm, and its competitors. This information is synthesized and summarized for the benefit of the portfolio manager, who must decide whether or not to invest in a particular company's stock.

A small shop has essentially a part-time portfolio manager who barely has time to keep track of his own current investments, much less evaluate new ones. Many small investment shops claim to visit company management and research company customers and the competition. Few actually do it. I was embarrassed when senior managers of our bank sometimes made such representations to clients and prospects. Aside from our portfolio manager's frequent trips to McDonald's, however, I can't really say that I ever saw us do these things. Small shops can't afford to!

The industry has changed dramatically from the time when a "customers man" (what they used to call brokers sixty years ago) sold stock to individual investors. These brokers offered clients recommendations which were guided by the stock broker's research department, which maintained proprietary research data. Now, however, the sort of information over which retail brokerage houses once had exclusive domain is easily attainable by anyone with a computer. The competition for information has become intense. It is no longer sufficient to be able to retrieve the data, now the spoils go to those who get it first. Whoever gets the "first call" has an opportunity to cash in on big news. Anyone else is too late.

Local trust companies, individual brokers, small investment shops and certainly individuals play second fiddle to the fast growing and cash rich mutual fund and hedge fund complexes. These institutional investors are generating enormous commissions, even at extremely low institutional commission rates. These commissions entitle them to special consideration.

With more than $3 trillion under its roof, if Fidelity wants its brokers' analysts to give them a first call on new recommendations, Fidelity gets it. By the time that a retail broker gets the story explained to them, Fidelity has already decided whether or not to invest a part of its treasure chest in that idea. (In other words, it's too late.) In fact, Fidelity's own marketing blitz emphasizes this factor. Several years ago the company set the advertising industry abuzz by creating commercials which aired each night that included the day's headlines in them. The commercials implied that for viewers, the headlines are news. For Fidelity, they're history. Fidelity's analysts have already anticipated the news and its consequences, watched the story unfold, and traded securities based on the news long before retail investors even heard the headline.

Fidelity brazenly asked for and received access not only to brokerage analyst reports and recommendations, but also to the spreadsheets which the analysts use to develop their conclusions. And Fidelity didn't just ask for a copy of those worksheets. Fidelity was able to get permission to go online and look at the analysts' worksheets live, via an internet connection. No retail broker in any company would receive permission to inspect its analysts’ spreadsheet assumptions.

SAC Capital Advisors is a multi-billion dollar multi-strategy private asset management firm founded by Steve Cohen in 1992. SAC trades so frequently and aggressively that on some days SAC is said to comprise a meaningful percentage of daily trading volume by itself. If there is an analyst on Wall Street with anything meaningful to say, which is in and of itself a questionable premise (but I’ll leave readers to Andy Kessler’s “Wall Street Meat” to address that question) then SAC has heard the news and traded on it before your local broker has even opened his Outlook software to glance at the morning e-mails.

Next post: The Advantages of Investing in Mutual Funds

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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