It may be hard to believe, but it was only last autumn when, in what seemed to be a blink of an eye, our capital markets turned upside down. In a matter of months, enduring U.S. investment banks literally disappeared while formerly strong, independent investment houses became neither. In the meantime, the Feds have been relentlessly nationalizing the U.S. financial system. Sadly, we’ve already gotten used to politicians of all stripes skulking around Wall Street.
This has been no simple move along the curve for the financial markets. This is a big lurch in the evolution of the markets. In broker/dealer world, the battle for survival is underway.
Already this turmoil is applying stress to firms and advisors up and down the industry, putting all sources of income under pressure and squeezing margins. Commission income is down, asset management fees are down, revenue from product companies is down. These conditions are requiring us all to take a serious look at how we’re going to do business. Quickly, too, if we’ve any chance to rebuild and gain consumer confidence, which, by the way, has reached an all-time low.
Among the competition that remains–and the banks and wirehouses may have been humbled, but remain formidable forces–the independent channel has the best opportunity to win client trust. Without the inherent conflicts of investment banking and without ties to product manufacturing like the wirehouses, independents are uniquely positioned to satisfy fiduciary responsibilities by serving investors’ best interests. It is a message that’s coming increasingly clear to a substantial chunk of the Wall Street sales crowd weary of bad press and tarnished brands.
But not everyone is going to make it through this market transformation. The landscape is changing dramatically, and it’s reasonable to think that more than a few firms and a good number of advisors are in peril. Said another way, many advisors and broker/dealers who were in the investment business six months ago won’t be six months from now. Not to be too Darwinian, but the survivors in this competition will be the fittest–those companies and advisors that, despite the complexity, confusion, and uncertainty of this marketplace, carefully assess the landscape and move forward with a smart strategy. That strategy will not only rely on reputation, sheer size, or brand, but the quality of product, advice, and service offered. All of these are good for investors, of course, and in turn good for advisors and their firms.
Setting aside the inevitable pain that comes with a transition of this sort, the end result will be a stronger, and much leaner, industry. We are still in the early stages of this evolution, if you will, but in my opinion there are a number of distinct strategic developments already taking shape, the final convergence of which will shape a new order of the independent broker/dealer industry.
An Advisor Free-for-All
When major players like Merrill Lynch and Wachovia can’t survive on their own–the former now acquired by Bank of America Corp., the latter absorbed by Wells Fargo–and Smith Barney and Morgan Stanley are left to create a joint venture, advisors know the brokerage world is hurting. For many, the thrill is simply gone–and ultimately they may be gone, too, either to another broker/dealer or perhaps to head out on their own. A growing number are ‘selling’ their books upstream. A bunch are leaving the business altogether.
At the same time, though, good financial advice is needed more than ever. That means that demand for top-producing advisors will be strong across all levels of the continuum. It is no surprise that the dually registered and RIA space seems be winning the competition. Why shouldn’t it? It is logical that a successful advisor would want to control her own destiny after years of working for big-box corporate firms. The result should be happier advisors who are better prepared to serve the expanding needs and demands of their clients.
To their collective credit, the wirehouse firms are stepping up with aggressive retention package offers and improved payout ratios. But the trend toward independence is already in motion. Independent broker/dealers such as my own firm (Geneos Wealth Management), Commonwealth Financial Network, and Raymond James Financial Services Inc., to name just a few, report record levels of interest from brokers and advisors, including those who want to escape Wall Street firms.
But all of this hunting and gathering favors the industry’s most productive advisors. Smaller producers are likely to be increasingly de-selected from the population through reduced payouts and declining income. The slumping market alone plays a role in lower compensation, but many broker/dealers are downwardly adjusting their compensation formulas at the same time. On the whole, payout schedules are being made steeper, with a lot more differentiation between low production and high production. It’s probable these payout models will shift to become even more differentiated, and to reward even fewer advisors doing the specific kinds of business that particular broker/dealers want. One way or the other, there’ll be fewer folks in the hunt.
Next Stop: Consolidation
All of this, of course, rolls up to the broker/dealer level and firms up and down the food chain are feeling the pinch of declining revenues. Since the stock market peaked in October 2007, executives with independent firms and their reps have watched assets and fees dwindle, with many facing a drop in revenue of 20% to 40%. It has to be worse for those operations that made risky bets in investment vehicles like sub-prime mortgages and private partnerships. They’re not only looking at a loss of cash flow but the strong likelihood of stepped-up regulation that will require heavy investment to comply.
All in, there are plenty of B/Ds out there that may need a lifeline. Of the 5,000 or so firms registered with FINRA, around 90% are considered ‘small,’ meaning they have fewer than 150 employees and $50 million in assets under management. At least half of that group could be described as ‘micro’ with 10 or fewer employees. Surely these smaller independents are realizing that in order to survive they need scale. The retail brokerage business is, after all, a scale business. As a result, there will likely be a rash of deals involving firms that desperately need capital. By all appearances, the number of sellers is growing dramatically and the number of buyers is consolidating.
So which broker/dealers will survive? As in other industries, those shops that are well differentiated from the competition and capable of attracting and retaining talented investment professionals will be the winners. Firms unable to distinguish themselves are going to have a difficult time in this market. Moreover, as the industry continues to evolve, it will get even more difficult to find their role in a much more competitive industry.
But this isn’t necessarily about size. There is likely to always be room for small niche players, really large firms that can, or try to, be all things to all people, and those in the middle. My bet is on the middle. It’ll be increasingly tough for the small firms to keep up going forward, and too often the really big independents are just mimicking the wirehouses. Mid-sized firms, on the other hand, tend to be large enough to fund infrastructure but small enough to stay focused on what they’re really good at.
In the meantime, Washington has assumed a dramatically expanded, and likely permanent, role in the business of financial markets. Policy makers have gone to great lengths to stabilize the monetary systems, to support individual companies whose failure might pose systemic risks, and to prevent a deep economic downturn. No one knows how well the Feds will work with the Street to develop effective regulatory and monetary policies, or what those responses may mean for the long-term health of the global capital markets. What is certain is that there will be reforms of finance and many other sectors.
Though little has occurred through this crisis to discredit the system of free-market capitalism, it’s very likely the SEC and FINRA will have their figurative hands in the industry to an extent few imagined possible, in no small part due to the fallout from the Bernie Madoff mess.
While more regulation may result in some good, it will most definitely come with a substantial burden. For smaller firms already reeling from plummeting fees and shrinking revenues, increased compliance costs could very well wipe out what profits are left. Those without a capital-rich corporate parent, or a capital cushion of their own, will have to find one or risk going under. I suspect there will be an awful lot of firms looking to offload most of this new regulatory burden on a partner in the next year or so, no matter what happens with the market.
For everyone left standing, investment quality and open architecture will be absolutely essential to success. The days of in-house offerings and programs have passed. From here, the speed of migration from proprietary products to open architecture investment platforms will increase algorithmically as investors seek objectivity, quality, and broad diversification. True open architecture, especially the kind that looks beyond simple performance and emphasizes due diligence and process, will align with both client goals and regulatory scrutiny. B/Ds structured with these ideals as key ingredients will have a distinct advantage in the new world.
As unpleasant as this transformation has been, and will be for a while, the broker/dealer industry is in a period of great opportunity, a time when sound, prudent financial advice will be needed more than ever before. It’s going to push us all into the flight to quality. At the same time the increased demand for topnotch advisors will put more emphasis on risk-averse value propositions and cutting-edge technology.
The financial crises of 2008 serves as an ultimatum to both regulators and the investment industry to swiftly adopt a more integrated risk management and product delivery framework or face irreparable loss of confidence by consumers. Those financial services companies that demonstrate the most flexibility and awareness will likely survive the crisis. Those who seize the extraordinary opportunities that arise during periods of uncertainty will very likely prosper.
Russ Diachok is the president and CEO of Denver-based independent broker/dealer Geneos Wealth Management. He can be reached at firstname.lastname@example.org .