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KMW Blog Oct 21, 2016: The Visual Capitalist charts the march of the machine

Posted: Oct 21, 2016JK: The Visual Capitalist charts the march of the machine
Published: Oct 21, 2016Misc: The Robo-Advisor Arms Race
Jeff Desjardins of the Visual Capitalist has published a a graphic that depicts the arrival of big investment management firms into the brave new world of robo-advice spawned in 2010 by a couple of startups. The financial sector has evolved from a transaction fee based revenue model to an asset management fee whereby the "financial advisor" collects a percentage of the asset value under management regardless whether its value is up or down at the end of the year, and a percentage of any value gained by the assets under management. Sorry, the financial advisors do not share in your pain when your portfolio ends up down. The transaction fee model where the financial advisor and his/her firm receives a commission based on the value of a stock purchase or sale had its hey-day during the eighties when brokers were encouraged to "churn and earn". Brokerage firms specializing in high risk markets such as the Canadian juniors would let their clients buy stock without money in the account on the feigned expectation that payment would arrive by the 5 day settlement. By the tenth day the broker would start pressuring the client about settling the trade, and by the 15th day the credit department would sell out enough stock to settle the debt if the broker had not already achieved this task. If the entire account had to be liquidated and a debt remained in it, the financial advisor would become responsible for it, and if he or she could not pony up the capital to make the debt disappear, the firm would make arrangements to enslave the advisor in a repayment scheme that could involve hanging paper on his or her clients in which the firm's principals were loaded up. By the end of the month all accounts had to be settled by the fifth day of the trade so that when the regulators examined the month end books no firm was offside and the lucrative business of loan-sharking to gamblers remained invisible. A good broker could squeeze two such trade cycles out of every month, 3% in and 3% out for a 12% monthly commission on the value traded by the client. Meanwhile, once a debt was beyond the 5 day settlement, the account was effectively treated like a margin account and charged an appropriate interest rate on the outstanding debt which the firm did not share with the financial advisor.

This lucrative business model came to an end in the nineties when commissions were deregulated and momentum traders moved their accounts to the discount brokerage firms like TD Greenline that popped up. Clients could no longer run debts beyond the 5 day settlement, which eventually dropped to 3 days, but they paid a lot less for their trading activities. They also ended up with 100% responsibility not just for their winners but also their losers, the secret bargain behind having a full service account. The model of a full service broker generating commissions from transactions quickly fell apart as it became apparent that clients would soak up their full service broker's advice, conduct a token trade with that broker, and do a much bigger trade through their vastly cheaper discount broker which provided little more than trade execution. Necessity forced the financial sector to move to a fee based asset management model where communication with the client was minimal and the goal was to preserve and even grow the client's capital. In contrast the transaction fee based model inflicted tremendous leakage on the value of client accounts except during the expansion part of bubble markets which usually erupted around some exciting new discovery with area play implications. Rather than treating clients as a flock of sheep to be fleeced and eventually devoured as mutton, the financial sector started treating investors as a herd of cows to be milked like those humans stuffed in the pods of the Matrix fed an illusory virtual reality.

The financial sector continued to cater to the resource juniors by seeking high net worth clients to whom they could flog private placements under the "accredited investor" exemption. Private placements used to have a 12 month hold restriction except when washed through so-called offshore "exempt institutions" in places like Switzerland, which made them a very risky investment mechanism for a junior's exploration play speculation cycle rarely lasted more than 12 months. But at the turn of the century the hold period was reduced to 4 months which was short enough for the money not to have been utilized to kill an exploration play, and long enough to prevent pre-selling, the abusive practice that killed the short offering memorandum as a financing vehicle for the juniors. These SOM financings, which were called "statement of material fact" offerings during the eighties during the reign of Murray Pezim, did not require a purchaser to be "accredited" and had no hold restriction. The new four month hold private placements were lucrative because the brokers could collect as much as 10 and 10 on the value of the transaction (10% commission in cash or stock and 10% bonus warrants) collected from the company rather than the client. More often than not the company would be bullied into spending money on stock promotion that kicked in right around the time that the 4 month hold restriction ended, even though the private placement boiler plate stipulated that nothing of the sort should be undertaken, enabling the placees to clip the warrant and flip the stock. The goal was to get back the private placement capital; if more was obtained it was a pleasant surprise. The broker then went to work finding a new private placement for the client's recovered capital, while the client enjoyed a free or low cost ride on the future success of the junior thanks to the warrant which can have a term as along as 5 years.

The bear market that began in 2011 gradually choked off the private placement mechanism as placees discovered that there was no after-market in which to unload their paper and eventually learned not to do private placements. Part of the problem was a technological innovation called algorithmic trading, essentially software that fed orders directly into the order book, and the "day trading account" which was exempt from borrowing stock for short sales so long as the account was flat by the end of the day. The ability to assure the latter was greatly helped by the elimination of the uptick rule for short sales which enabled algo traders to pound the bid side of the order book in order to precipitate discouraged long shareholders to sell their positions.

The private placement model, which relied on trading startegies, was not consistent with the fee based asset management model, which worried the bigger bank controlled financial firms to whose assistance the regulatory system rallied with the invention of the client relationship model and a suitability requirement which enabled clients to weasel out of bad trades by claiming the broker allowed him or her to make an unsuitable trade. Since the 2008 crash clients aged 55 and older have discovered that the compliance department of their firm will refuse execution of a trade deemed "risky" and thus unsuitable even when it was an unsolicited order from the client. Much to the chagrin of the bankers the regulators evolved a zealotry based on the principle that a human advisor is a weak link in asset management because of a vulnerability to self-serving or ignorant advice that harmed the client's interest. The regulators even discovered that the brokers were stuffing their "managed" accounts with products that had all sorts of hidden up front and trailing fees. The penny stock practice where a broker's job was akin to that of a mushroom grower, namely keeping his clients in the dark about the true status of their investments and thus prolonging their ownership until was hopelessly too late, became institutionalized at the mutual fund level.

Not so much discussed is that the market generally engages in a random walk which a highly diversified portfolio will follow in a manner that does not allow blaming anybody for malfeasance or stupidity. Out-performing the market requires a manager to either be lucky or fearlessly ride an emerging trend. The recent absence of discernible trends that eventually capture the general public's imagination is a reason hedge fund returns have suffered in recent years to the degree that clients are pulling their capital and putting it into market index linked vehicles. The awakening of investors to the random walk nature of the market was picked up on by entrepreneurs who understood that it was possible to compile a detailed risk and objective profile for a client, convert that into a portfolio with a corresponding structure, and stuff each category with appropriate "structured products" such as ETFs and mutual funds that diversified away the catastrophe risk associated with individual securities. No need to worry that a German icon like Volkswagen would cheat on diesel emission tests, or an Internet company like Yahoo would see 500 million passwords scooped by hackers, an energy giant like BP would suffer a Deepwater Horizon blowout, or a banker like Wells Fargo would support a culture of systemic client abuse.

The startups recognized that the classification of products was an ongoing task with a fixed cost whose outcome was very scalable. It is the same principle that lies behind the newsletter model; generating good ideas involves hard work, but the result can be shared with an open-ended subscriber base. The harder part was collecting the risk and objective profile for each client and keeping it sufficiently up to date to stave off accusations that nobody paid attention to a client's changing needs and circumstances. The newsletter industry does not have that problem because by definition each subscriber is anonymous. But even the profile maintenance task can nowadays be automated thanks to online accounts whose owner's privileges can be frozen if certain periodic questionaires are not completed. Of course since all asset classes engage in random walks not always correlated with each other, there had to be some way to maintain the correct balances, a tedious task for a human advisor but not for software that compares the daily asset class values with their theoretical portfolio allocation and automatically rebalances the positions in each class by drawing on a pool of pre-vetted instruments.

With a modest computing cost and a fixed classification cost it became possible to cut the management fee to a fraction of the hedge fund fantasy of 2 and 20 for which the bankers lusted (2% of portfolio value and 20% of any gains). And so was born the robo-advisory which offers a huge cost advantage over "full service" asset management accounts presided over by human beings which the regulators viewed as the weak link in financial services. The bigger firms have no choice but to embrace the lower cost robo-advisory accounts and are happily doing so because it enables them to get rid of the expensive human overhead and the risk that even a well-meaning advisor could make a decision that the market's random walk wrong-foots and, because that broker's choice is out of step with the herd, exposes that account to "suitability" litigation from the client.

I've been talking and writing about this process for a few years, but the Visual Capitalist's graphic version makes this problem more readily intelligible. With regard to the resource juniors, it is time to treasure the few remaining financial advisors who still serve clients interested in a two-way dialogue about high risk high reward investments, and get serious about lobbying for greater freedom for retail investors to participate in private placements without any compensated intermediary. That means getting rid of the "existing shareholder" requirement of the exemption that allows non-accredited investors to buy up to $15,000 worth of private placement stock per company per 12 month period, and streamlining the paperwork so that participation in a private placement is a simple digital event rather than the dinosaur like process of today. Whichever way an investor other than the ultra rich looks at it, their investment future consists of robo-advised mediocrity or 100% personal responsibility for investment decision. And judging by the explosion of "family offices", even the ultra rich are giving up on the financial advisors.


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