How to avoid becoming Wall Street’s muppet

A former executive director of Goldman Sachs caused a stir earlier this month when he spurted that some of the firm’s higher-ups deride clients as “muppets” — Wall Street slang for rubes.

A recent Yankelovich survey found that four in 10 investors believe investment companies are unfair — joining the ranks of credit card companies, CEOs, the federal government and of course, lawyers.

Goldman isn’t the only offender. There is no industry more ridden with conflicts of interest and misaligned incentives than investment management. David Swensen, who deftly oversees Yale University’s endowment writes: “Relationships with external investment managers provide a fertile breeding ground for conflicts of interests.”

He noted that while investors seek high risk-adjusted returns, investment advisers “pursue substantial, stable flows of fee income.”

Agent secrets
So if you have accumulated a few bucks and want to leave your investing plans to an expert, your conundrum is: How do I delegate in an industry full of charlatans? How do I protect myself from being someone’s muppet?

The answer comes from studying the practices of elite endowments, pensions, and wealthy families.

Unlike everyday investors who blindly trust “experts,” smart institutions have identified and actively manage “agency risk.” An agent is anyone who you trust to handle, your money.

Hiring an agent creates risk — big risk — because agents will not always act in your best interest. If you own your business, you have no agents, and no agency risk. You are in control. Conversely, agency risk must be managed.

Do you own shares of a public company? Its directors and management are your agents, operating the business on your behalf. Managers want to keep their jobs and receive greater compensation. Directors enjoy their board fees and the prestige. Management and directors often develop an entire dynamic keeping one another happy and spending your (shareholder) money in ways that you wouldn’t. Activist hedge funds like Starboard Value and Opportunity Fund seek out companies where profits are being squandered through such misalignments and demand changes to better serve shareholders.

Own a mutual fund? That’s another layer of agents. Fund managers are hired to outperform an index. To do this, usually requires concentrating a portfolio around fewer stocks. But mutual fund managers learn early that if one of their bets is wrong, they can lose their jobs. To survive, managers begin “closet indexing,” owning many stocks, which means they’ll rarely justify their fees, but they won’t get fired either. That’s not in your best interest.

Have a wealth manager? Now you have a third layer of agency risk to pick the fund managers who pick the securities. Large firms like Goldman get payments from fund firms for “distribution” — channeling client (muppet) money into their funds. Worse yet, firms sell clients their own proprietary funds and make money from both the fund and from putting you into it.

With three layers of agents, everyone has their hand in your pocket. That’s what defines a muppet!

MarketRiders is designed to nearly eliminate agency risk. We make being a do-it-yourselfer really easy and fast, like painting by numbers — we promise! But if you are not a do-it-yourselfer, here are three ways to reduce agency risk:

1. RIA vs. broker: Do you know the difference between a registered investment adviser (RIA) and a broker? They are as distinct as chiropractors are to orthopedic surgeons.

2. Index funds vs. actively managed funds: Most investors don’t know the difference between an index fund and an actively managed fund. If you are one of them, do some homework. With an index fund or exchange-traded fund, you can save on fees and replace fund managers with computers that buy every stock in a particular market. Performance? The statistics are indisputable — owning active funds is an expensive loser’s game. That’s one reason why Vanguard Group, which created index funds, is now the largest money manager in the world with $1.75 trillion.

3. Clearing brokers: Where your money is located is a critical decision. Make sure that your money is held by what is called a “clearing broker,” like Charles Schwab or Fidelity Investments — not your local independent broker dealer. Clearing brokers are much more regulated and plugged into what is called the Depository Trust and Clearing Corporation (DTC). This dramatically lowers the risk of fraud and helps insure that no one but you can move money out of your account.

Enjoy watching the Muppets; don’t become one. Having your own account at well-known firms such as Schwab and Fidelity, with an independent adviser (not a broker) buying you a portfolio of index funds, means you’re investing with fewer strings attached.