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Industry Spotlight > Broker Dealers

To Succeed in the (Near) Future, BDs Must Avoid the Winner's Curse

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Pershing has been delivering slices over the past year of its Broker-Dealer of the Future II research, which focused on six big transformations that independent BDs must embrace if they wish to succeed in the future. A follow-up to a 2008 study on broker-dealers, this study was based on research conducted by FA Insight in 2012 and on data from the Financial Services Institute’s “Broker-Dealer Financial Performance Studies.” FA Insight conducted telephone interviews with 50 registered reps of broker-dealers that included wirehouse, regional, bank and independent broker-dealers, supplemented by interviews with the leaders of a half-dozen broker-dealers. The clearing and custody firm began releasing the findings of its new study in December 2013.

The already-released first three “transformations” suggested that the Broker-Dealer of the Future would identify ways to avoid “commoditization,” foster organic growth of existing relationships and build a sound economic model.

The final three trends, released in early January 2015, urged forward-thinking broker-dealers to:

  • Avoid the winner’s curse of high-cost recruiting

  • Espouse advisory services

  • Demonstrate stability and longevity

On recruiting, the study reported that over the last five years, competition for top advisor talent has led to sharp increases in recruiting bonuses and higher payouts for recruits, but the “winners” in those highly competitive recruiting wars may in fact be losers over the longer term, since those incentives “may cause permanent damage to the economics of the winning broker-dealer.”

This “winner’s curse,” as economists call the condition, is borne out by FA Insight and FSI data showing that overall recruiting-related expenses for the average BD rose 14% in 2011 and 24% in 2012, matched by costs per recruit.

In addition, while rep departures from BDs stayed constant at 15% of the total rep force from 2008 to 2012, the rate of additions from recruiting has declined, and more of the most valuable reps—the bigger producers—are departing. Recruiting bonuses not only affect a BD’s bottom line, but also “seem to erode retention” of the existing rep force. So how to solve the problem? The study argued that “for recruiting to be profitable, it must be based on a sound economic model that focuses on value-added services and targets” reps whom the BD “believes it can best serve.”

The Trend Toward Fees, Focused

As for espousing and embracing advisory services, the study was blunt: “The true test for the competitive strength of a broker-dealer today is its ability to support financial advisors who prefer an advisory model to conduct their business.” That competitiveness is driven not just by the overwhelming trend within the investment industry toward fees, but also by research showing that BDs with above-average profitability had “a substantially higher level of advisory fees in their revenue mix.”

Why is that the case? One reason the study cited is the revenue benefit for the BD when a rep uses the corporate RIA. The BD may charge 15 to 20 basis points for its services and may derive revenue from the funds and fund managers on the platform that it usually chooses itself. Finally, the revenue from those services is not subject to the competitive pressures of the BD’s payout grid, which we’ve seen affects a broker-dealer’s bottom line in the “winner’s curse” scenario.

Therefore, the study argued, it is in the best interests of the broker-dealer not just to encourage its reps to take a fee-based approach to their businesses, but also to encourage the use of the BD’s RIA rather than have reps form their own or use third-party TAMPs. “What should be without compromise” in a broker-dealer’s relationship with its reps is a “broker-dealer’s conviction to not be relegated to a vendor role, where they are merely one of several relationships,” the study warned. Instead, a BD’s advisory platform should provide advisors and end clients with experienced operations, integrated technology, due diligence of the investment options on the platform, and legal and regulatory support. Ironically, the study noted in its conclusion, such a platform “is highly sought by a market outside of the FINRA and broker-dealer jurisdiction: large RIA firms.”

Longevity and Stability

In looking at the importance of the sixth and final “transformation” that the Broker-Dealer of the Future must embrace, the study began by delivering some sobering statistics on the broker-dealer industry itself. Using FINRA data, FA Insight reported that 863 broker-dealers closed their doors from year-end 2007 through May 2014, bringing the total number of BDs to 4,142. Still, the study argued that “longevity is perhaps the most underappreciated advantage of working with a broker-dealer,” when that BD enjoys “deep capitalization to withstand the fluctuations of volatile equity markets,” along with “carefully constructed custodian agreements” to protect individual investors. For advisors, broker-dealers must exhibit a “sustainable strategy” that will provide them with a “solid foundation to build a practice.”

While many advisors like to complain about their broker-dealer’s compliance department (think of the pejorative phrase used by some reps to refer to compliance as the “sales prevention department”), reps searching for a Broker-Dealer of the Future should appreciate a compliance department that during the financial crisis of 2008-2009 “showed the importance of compliance as part of the culture of the firm.”

Having such a “right culture” with its system of checks and balances not only helps protect the firm against bad publicity, but also the assets of individual investors, the study argues, and advisors themselves. The “right culture” must extend into the due diligence process of new products, the study said. While the tight margins of broker-dealers can make the marketing fees and high commissions of certain new products attractive to BD leaders, “compromising the integrity of the research process to capture such opportunities can have disastrous results.”

Looking at strategic longevity, the study recalled the sales of many broker-dealers over the past few years, which have made many BD reps “increasingly leery of the potential sale of their broker-dealer” because of the changes—not always positive—that come with an acquisition. To be successful in both organic growth and recruiting, therefore, the leaders of the Broker-Dealers of the Future must be able to “make a strong statement about [the firm's] own stability” and convince its advisors that they are “dedicated to the business and can handle succession issues.” Only then, the study concluded, will those successful broker-dealers “earn the trust of both financial advisors and individual investors, and have a bright future.”


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