Complexity as Job Security

| June 5, 2022 | 0 Comments

We’ve all heard stories about the guy at work who makes his job seem far more complicated than it really is so that he becomes harder to fire or lay off. Complexity as job security is nothing new.

And Wall Street product manufacturers are wizards at this.

In the 1990s, as mutual funds were becoming more prevalent because their fees (though high) were lower than the cost of your typical brokerage account, Wall Street came up with Separately Managed Accounts (SMAs), also known as “Wrap Accounts” because one single fee wrapped around the whole account and covered everything. The alure of wrap accounts was that you could have the same guy who ran popular mutual funds manage your brokerage account. And by owning the individual stocks instead of the mutual fund, you could hand-pick your capital gains or harvest your losses, so in theory they could be more tax efficient.

In practice, they were just more expensive. Few people took advantage of the ability to pick through the portfolio to actively seek out the losses. Also, remember that to properly diversify your portfolio, you need to include different kinds of investments like large and small company stocks, international stocks, bonds, etc. With a wrap account, each kind of asset requires a separate brokerage account, so instead of one brokerage account with a few mutual funds, you would have several brokerage accounts each with dozens of stocks. Monthly statements and trade confirmations could be measured in pounds, not to mention annual corporate reports, proxy notices, and annual tax reports. Not only were your brokerage fees higher, but at the end of the year your CPA would have to wade through all that paper to prepare your taxes, so their fees were higher.

I should also note that every time I compared the long-term performance of these wrap accounts to the same strategies in mutual funds, the mutual funds did better.

Wall Street is at it again with a twist on this old framework called “Direct Indexing.” Since many investors have ditched expensive managed mutual funds and brokerage accounts in favor of cheap index mutual funds and exchange traded (indexed) funds (ETFs), Wall Street has come up with direct indexing, which is basically an old wrap account but this time tracking an index instead of managed by a fund manager.

The pitch?

Track an index but own the individual stocks so you can harvest the losses when they occur or possibly exclude industries you don’t like (such as tobacco or oil).

The catch?

The fees are much higher than index mutual funds, so your performance will suffer.

Harvesting the losses isn’t as efficient as it sounds. You can accidentally create wash sales and convert tax-favored qualified dividends into higher tax ordinary dividends if you aren’t very careful.

There are a lot more securities in the account; 505 stocks to track the S&P 500, so even more work for your CPA and your mailman.

One account won’t give you proper diversification so you may need several of these accounts.

Why do brokers like these accounts? They can charge higher fees for the more complicated product and the allure of greater tax efficiency. But it’s really just about the fees. Of course, there is one huge bonus for the broker who sells you this concept. After you own one of these accounts for a few years, almost all of the stocks will have built-in capital gains, making them more expensive to sell and a LOT harder to change your investment strategy or switch to another advisor who doesn’t use the same products.

In the long run, on average, index mutual funds outperform managed funds largely because their fees are lower. Because of their lower costs, index mutual funds and ETFs will likely outperform these accounts, too.

Simplicity is the ultimate sophistication  – Leonardo da Vinci

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/investment management with Blankinship & Foster, LLC, a financial coach specializing in financial health for physicians and people in or preparing for retirement. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.

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