This blog post continues my series on complex investments.
If you have followed my work on investment complexity, you might have wondered how investments came to be so complex.
The answer is simple: complexity is highly profitable. In fact, complex products and strategies have a number of traits that are desirable to Wall Street firms:
- They require the use of experts to understand them for the client;
- They are difficult to commoditize;
- Fees and profit opportunities can be buried in their construction and maintenance.
For Wall Street firms, this is a trifecta. Most broker-dealers have a ready network of licensed salespeople who can sell complex products and strategies to their clients; they can use complex products to blunt the now complete commoditization of their traditional stock and bond trading business; and they have various business units that can all profit from their respective participation in the creation and maintenance of complex products and services.
Given the way complex products and services fit with Wall Street business models, there is a perverse incentive for brokerage firms to increase complexity.
Complexity as a Response to Pricing Pressure
Wall Street firms have faced at least two historical events when the commission-driven business model was challenged. In both instances, they responded by moving away from the threatened area and into an adjacent area with increased complexity.
The first event was the 1975 deregulation of fixed commissions, better known as “Mayday” because it went into effect on May 1, 1975. In the time leading up to Mayday, brokerage firms had charged fixed fees for executing stock trades. This removed competitive pressure from commissions and the firms enjoyed high profit margins.
After Mayday, Wall Street firms were free to discount their commissions and this introduced competition into commission pricing. It is no accident that the discount brokerage pioneer, Charles Schwab, started his eponymous firm in 1973, and started offering discounted stock trades on May 1, 1975.[i]
The effect of deregulating commissions was significant. As Jerry Markham writes[ii]:
Between 1970 and 1989, commission charges for institutional investors dropped on average from twenty-six to less than five cents per share. The result was that revenues from commissions for broker-dealers declined from about 65 percent of industry revenues in 1972 to about 40 percent in 1983 and to about 17 percent in 1989. Commissions made up over 50 percent of Merrill Lynch’s total revenues in 1972 but only 15 percent by 1988.
These declining commissions were doubly significant because they were most pronounced for institutional investors. Institutions not only had the most negotiating power, but their share of trading volume was growing dramatically over the same time period. This was a one-two punch to broker-dealer commission revenue.
The response from Wall Street firms was to take the asset facing pricing pressure, equities, and package them into more complex investments, mutual funds. The mutual funds carried high fees of four to six percent and also paid annual “trailers” of one-quarter of a percent or more.
Furthermore, mutual funds fit right in with the typical Wall Street business model. Firms could hire portfolio managers to run the funds, use their trading desks to execute the trades, and have their sales force sell the funds to their clients. At Wall Street firms, many beaks could get wet at the mutual fund troth.
In addition, mutual funds provided consistent revenues for issuing firms. The internal management and 12(b)1 fees were typically from 1.5 to 2.5 percent per annum and were deducted quarterly. These consistent revenue streams smoothed out broker-dealer revenues and were much less volatile than transaction commissions, which ebbed and flowed with the markets.
While mutual funds seem relatively simple by today’s standards, they represented a leap in complexity that was an order of magnitude higher than simply buying stocks. Investors had to navigate dense prospectuses that covered a wide variety of issues, including:
- Fee structures;
- Investment strategy and discipline;
- Pooled investment structure;
- Tax considerations;
- Liquidity constraints;
Importantly, all the issues listed above are unique to the mutual fund vehicle itself and do not include any of the traditional economic and financial issues that are part of any equity investment.
The shift in focus from equities to mutual funds was instantaneous and sustained and the fund business grew from a small niche investment vehicle to the default in about a decade.
Indeed, in the wake of Mayday, mutual fund AUM enjoyed their highest five-year compound annual growth rates (“CAGR”) on record, notching gains of: 24.1, 26.3, 43.4, 39.3, and 31.4 percent from 1980 to 1985, respectively. [iii] In the 10-year period from 1975 to 1985, mutual fund AUM grew from $45.87 billion to $495.39 billion, an increase of 9.8x, for a 10-year CAGR of 26.9 percent.[iv]
For higher resolution charts, click here.
Chart 1: Mutual Fund Assets Under Management and Five-Year Rolling CAGR
Driving the dramatic increase in AUM were new sales in mutual funds, which also expanded at their highest growth rates in the years immediately following the 1975 Mayday deregulation.
Chart 2: Mutual Fund Annual Sales and Five-Year Rolling CAGR
A new page had been added to the Wall Street playbook: if a revenue stream became commoditized, take that product and use it to create a new (and more complex) product, to protect the firm's profit margin. In my next post, I will examine how this page of the playbook was used again 27 years later in the fixed income markets.
Learn more about complex investment expert Jack Duval.
[ii] Jerry W. Markham, A Financial History of the United States, Volume II, (New York, Routledge, 2001), 182.