When advisors look for a new broker-dealer, most don’t consider the impact of a bear market on these firms — they should.
Between 1926 and 2017, we’ve experienced eight bear markets. Their duration ranged from six months to 2.8 years, while the severity of the decline varied from about 22% to an 83% drop in the S&P 500.
The 1973-1974 stock market crash was an especially deep correction, with the market losing over 45% of its value. (The crash came after the collapse of both the Bretton Woods system and the Smithsonian Agreement, causing deep dollar devaluation.)
For broker dealers, the 1973-1974 crash was extremely tough. As Raymond James explains on its website, “During the economic downturn of 1973 and 1974, with the survival of the firm in the balance and capital reserves dwindling, Tom James [sold] off portions of his prized rare coin collection to help keep our doors open.”
At a home office visit to Raymond James more than a decade ago, a recruiting executive shared that one factor that helped pull the firm out of its financial difficulties during those times was its expansion into the independent channel.
The employee channel is more vulnerable to market shifts, because it is saddled with high branch overhead items, such as leases, branch managers, compliance officers and sales assistants. As broker-dealer revenue drops, these costs remain largely constant.
The independent model, meanwhile, flips this overhead over to advisors, and in exchange they receive much higher payouts — making the broker-dealer more resilient by reducing its overhead.
In a research report issued earlier this year during the correction, Goldman Sachs provided additional insights into which broker-dealers are more resilient and which are more vulnerable in a bear market. (The day before the report was released, March 23, the S&P reached a year-to-date bottom of 2,237.40, though it’s since recovered.)
In the report, Goldman Sachs analyst Alexander Blostein downgraded Raymond James to sell, commenting, “The vast majority of RJF’s revenues are cyclical, tied to either equity markets (51%) or interest rates (16%), and are also exposed to elevated headwinds in Investment Banking and Capital Markets/Trading (13%).
These remarks and the related downgrade — which could be applied to many of the wirehouses and regional broker-dealers — contrasted with the report’s assessment of LPL Financial, which was raised to a buy.
The report viewed LPL as a more “pure-play” model, with Blostein expecting the firm’s revenue streams to be relatively immune to elevated market volatility, cash balances likely to spike, and recruiting growth to increase. Part of the expected recruiting boost, the analyst said, could come from smaller advisory practices looking to partner with stronger firms, creating more M&A activity for LPL.
More Vulnerable BDs
Our recruiting firm sees small broker-dealers, largely those with fewer than 100 advisors, as especially vulnerable to a bear market and certainly more vulnerable to a downturn in the markets than they were in 2008. A larger percent of their budget now must be allocated to compliance expenditures.
We surveyed small- and mid-sized broker-dealers and asked, “What percent of your budget goes to compliance related expenses?” The amount varied from 30% to 50% of their overall budget.
We also asked, “How has your compliance budget increased over the last five years?” They all said the same thing: It’s resulted in a 10% increase to the overall budget.
In addition to broker-dealer size, other factors come into play when it comes to their areas of potential weakness in downturns: