One of the most opaque and difficult to understand industries is the financial services business. This lack of transparency is done on purpose. It intimidates people to the level that we are forced to hire brokers and advisors to help us navigate the investment world. It's how the industry justifies it costs and fees.
But this whole industry is ripe for disruption as soon as radical transparency hits it. In fact, we might even see the end of some iconic businesses as a result.
Let me explain.
Consider how an investment firm like Goldman Sachs makes its money. Like many investment advisors, Goldman has shifted away from a model where they charged a commission on every trade they made. Today, most firms charge you a fixed percentage of your assets they are managing for you--usually between 0.7% and 1.5% on an annual basis. The claim is that they charge you this fixed fee to help align their interests with yours; the more money they build for you, the more they get paid. Seems fair right?
Well, with radical transparency, this deal doesn't look as good as it did at first glance.
As you peel back the onion, you'll learn that the investment firm is still making money any time that complete a transaction in your name. If they recommend that you buy a mutual fund for your account, for instance, they get paid a referral fee by the fund. They also get paid a marketing fee. Of course, you never see those fees in your account--they're built into the mutual funds pricing scheme. That means you're paying for those extra fees one way or another--on top of the management fee they're charging you. It's all coming out of your pocket.
Another move that your investment firm might make is to sell you a proprietary fund--which is a fund managed by your firm. When your broker buys one of those for your account, not only do you pay a special broker fee of an extra 1%. That means that you're now paying your firm that fee, plus the management fee rake off the top.
Again, there's a reason none of this is very transparent to the account holders, you, but it significantly reduces your return and the ability to grow your wealth over time.
Yet another questionable move by the investment firms is something called "proprietary trading." This is when the firm will sell you a share of stock for your portfolio that it already bought. In other words, rather than going out to the market to buy the share from a random party, the firm will sell you one of its own shares. The catch is that your broker makes a commission off trades like this. They also make the spread on what they purchased for and what you bought for. It gets even worse when your firm looks at its order book and puts in trades on the open market to fill those orders. For example, if your firm knew you wanted to buy a share of a certain stock for $50, it could use its super-fast trading computers to buy it at $49.50 and then sell it to you for $50. While that might not seem like much of a profit, it adds up if you do this millions of times. Ultimately, the system is rigged against you.
I believe that we're on the verge of an age of transparency in investing which will put an end to practices like these. The music is about to stop and the investment firms will be without a chair to sit in. It's not unlike how the 401(k)-management industry took nosedive as soon as regulations ensured that people were aware of the fees they were paying on those accounts. It's no surprise that 401(k) management fees are down 30% since 1993--because people can now see what they're paying for.
So, as the age of transparency dawns, don't be surprised if the casualties mount as investors begin to realize what their advisors have been charging them for and the profits of these firms plummet. It might even be the end of iconic firms like Goldman Sachs. Time will tell.