sma equals ripoff

I continue to be amazed — although by this point I shouldn’t be — by the innovative methods the brokerage industry comes up with to take money from investors.
Today’s DMN features a Pam Yip story on separately managed accounts (SMAs), the latest financial vehicle brokerages are pushing. It’s generally for those with $100,000 or more to invest.
Starting an SMA means hiring someone from a brokerage firm to take the investor’s money and run it as if it were a little one-person mutual fund. The investors gets to set certain guidelines on how the money will be invested — say, “I want to be aggressive” or “I want a lot of international exposure” or “I don’t want to invest in icky tobacco companies.” But beyond that, the investor essentially cedes control of his money to the manager, who invests it as he sees fit to maximize return.
The major selling points: Managers can personalize the investments based on the investor’s goals. They can also give personal attention to investors and tailor transactions to investors’ tax needs.
What a load of bullshit.
In the story, Pam points out the major reason brokerages are pushing SMAs: It’s a response to their shrinking market share in money management. An increasing number of people have realized that brokerages are, at their core, a scam designed to maximize returns to the money managers at the expense of the actual investor. As a result, more people have been hiring fee-based financial advisors — the ones who charge a flat fee for advice instead of taking a cut of all your assets — and firing brokerages who have 1,000 different incentives to give investors bad advice.
But SMAs don’t fix any of the problems with brokerages. In some ways, they make the worse.
– First of all, they’re hella expensive. Fees for SMAs average 2 to 3 percent a year. In other words, if you have $100,000 to invest, you’re paying your broker, say $2,500 a year to manage it. That’s outrageous. Even mutual funds on the expensive end should never cost more than 2 percent, and you shouldn’t be on the expensive end. You can buy a very good index fund that buys the entire domestic stock market for a cost ratio of 0.09%. In other words, your investing costs can be cut from $2,500 a year to $90 and your money will be invested with lower risk and, most likely, produce higher returns.
And if your SMA manager chooses to buy any mutual funds with your money — and with only $100,000 invested, he almost certainly should to reduce risk — those mutual funds’ expenses are on top of the SMA’s. And I doubt he’ll be buying cheap index funds, since that would illustrate how unnecessary he is to the operation. He’ll be buying expensive crap, bringing your expense ratio up to an unconscionable 4-5%.
Maybe 4-5% doesn’t seem like a lot. But if your $100,000 is invested for 30 years at an annual return of 6%, it’ll become $574,000. At 10%, it becomes $1.7 million. The expenses brokerages add to your costs are a major, major drag on returns.
– You’re highly unlikely to get market-beating returns. Research going back decades show active managing of stock funds reduces performance, not increases. Index funds that just buy the entire market beat an average of between 70% and 80% of all stock funds each year. In other words, the “smart guys” you hire to invest your money, on average, take your money and lower your returns. It’s efficient market theory at work, Econ 101.
And while it is certainly possible for a given stock fund to beat the market in any given year, over the long term, indexes win. In the 1990s, despite a slew of funds throwing money at tech stocks (and we’re talking before the crash in 2000), the S&P 500 index beat 90% of all domestic managed funds, often by wide margins. As the great Burton Malkiel has written, if you’d put $10,000 in an average domestic managed fund in 1969, 30 years later, it would have turned into $171,950. But if you’d just bought an S&P 500 index fund — just bought the entire market and leave the stock picking to the fools — you’d have had $311,000.
And let’s assume for a moment that a brokerage really does have a money manager who can consistently beat the market — an extremely rare creature like Bill Miller at Legg Mason. Do you really think they’re going to be pulling the strings for some schlub’s $100,000 SMA? No, he’s going to be put on the biggest mutual fund the firm offers, like the $12 billion fund Miller runs. SMAs are going to be run by either the low fish on the food chain or as a part-time, no-attention job for more experienced types — which would put the lie to the “personalization” SMAs are supposed to be good for.
SMAs try to get around this underperformance by reporting their returns without taking into account expenses. That’s atrocious and unethical. To cite the example Pam does in her story, large-cap growth SMAs reported 13.7% returns through Q3 2005, versus 13.4% for mutual funds in the same sector. Sounds nice, doesn’t? Well, that 13.7% doesn’t include the 2-3% shaved off the top for the brokerage’s pockets. So what looks like overperformance is actually underperformance.
That’s fundamentally dishonest, and a symbol of the rank dishonesty that fills the whole business. The excuse an SMA-industry rep gives in Pam’s story — that some brokerage firms don’t know math well enough to be able to figure out real returns with expenses! — is the biggest load of crap I’ve heard in weeks.
– SMAs give brokerages incentives to be evil. If they’re given a free hand to do whatever they want with your money, that means they have a free hand to buy a bunch of crap. They can buy their own brokerage’s overpriced funds instead of others with lower expense ratios. Don’t like it? Too bad!
Brokerages have gotten into SEC trouble again and again for sketchy financial deals with mutual fund companies. The fund companies pay the brokerages — through marketing fees, i-banking arrangements, or other nefarious plans — to push their lame funds on customers. It happens all the time: Brokerages are given financial incentives to sell you bad product.
At least with a normal brokerage account, you’re free to ignore your broker’s crappy advice. But with an SMA, it’s not your call any more, and plenty of brokers will make decisions that feather their beds at the expense of yours.
Anyway, I get mad about this sort of stuff because this is a clear-cut case of big companies exploiting the ignorance of consumers to take their money. SMAs add precisely zero value to the world, and we’d all be in a better place if we could collectively fire the brokerage industry, buy a bunch of cheap index funds from Vanguard, and stop funding summer homes in the Hamptons with the savings of individual investors.
(As an aside: I’m considering starting a web site that would codify, in a user-friendly way, how to invest your money to maximize your returns, avoid the profit-rapists of the brokerage industry, and not have to concern yourself with stock picking. If any of you are interested in the subject — which I know falls outside the bounds of normal crabwalk.com content — I’d love any suggestions or thoughts you might have.)