November 30, 2018
"Your margin is my opportunity." ~ Jeff Bezos, referring to Amazon's competitors.
That's my favorite business quote of all time. It distills entire business school courses to five words. "Margin" is what is left over after a business pays its bills. For the sake of One Day In July, we consider this quote our operating plan.
Today I want unpack the financial advice industry, and tell you what I've learned. This is not my first rodeo - I didn't start my career in this business, though I've been studying it for two decades. I was trained in other industries that are much more competitive and have razor thin margins.
Margins in the traditional advice business, and financial companies in general, are huge. Operating margins north of 40% are common, where other industries average 5% to 7%. Increasingly, as index funds put pressure on the mutual fund business, financial companies are turning to their advice arms to generate profits.
While "Occupy Wall Street" has a better ring to it than "Occupy the Office of my Local Investment Advisor and Insurance Broker who Also Sells Annuities, is Kind of a Friend of Mine, But Never Really Mentions the Commissions the Funds are Also Paying Him," it's important to understand that the problem is not limited to Manhattan. It is widespread, and the distribution system of overpriced financial products winds its way through small offices, and big brands, all over America. This river of fees flows through fraternal organizations, churches, and conversations at youth soccer fields. Its tributaries quietly bleed the 401k savings of hard working people everywhere.
While not the topic today, remember that our argument at One Day In July is that it is exceedingly difficult to outperform a diversified collection of index funds at the same risk level. This task gets exponentially more difficult if you assume a fee stack on the client of 2% - 3%, when all fees (advisory, funds, trading, spreads, etc), are included. Considering that gains in a taxable account can be taxed above 30%, it's not like you're jumping over a hurdle on the varsity track team. It's more like your coach asked you to jump over the entire school, while doing your calculus homework at the same time. If you first name isn't "Warren" with a last name of "Buffett," your chances of outperformance are close to zero.
Many people in the industry know this, and they are afraid clients are going to ask about fees vs performance. If you are managing assets and not adding value, you are, as a manager, a living, breathing example of an economic rent. There are three ways financial advisors try to address this:
1. They hope and pray that clients will succumb to inertia and not spend the energy to decipher their full fee stack, and if they do, that the percentages will look small and not alarming.
2. With increased fervor, they hope and pray that clients will think they are "nice guys," and that a personal relationship will protect their margins.
3. They try to add layers, often under the guise of financial planning or estate planning, that protect the core profitable business.
Going back to the rodeo comment, this is what I sauntered into on my figurative pony, looking to disrupt. With a group of talented people, we started to build a box around the advisory business, knocking out many of their high costs, challenging their assumptions, and optimizing away waste.
This is where firms running the classic model, and that is the huge majority of them, are going to have a problem. I cannot think of a business in any industry that has converted successfully from "high margin, high salaries" to "low margin, appropriate salaries, and a lot of work." When headquarters does decide they need to address the competitive threat, we doubt their advisors will be interested, and we think they'll push back.
But we plan to tighten the box around them. And then we're going to squeeze it. And our investors will be the beneficiaries.