Friday, April 26, 2013

The Hidden Agenda Behind Retail Investment Proprietary Products

I despise proprietary investment products.  These are investment securities specific to one brokerage, usually created by its investment bank or wholesale asset management arm.  They've been around for years and need to go away.  Like mutual funds, they've outlived whatever usefulness they possessed at their creation.

Internal hedge funds are stupid and probably a conflict of interest.  The academic research on the inability of actively managed funds to deliver alpha over the long term is clear.  The high expenses and volatility of hedge funds magnify this deficiency.  Firms that create internal hedge funds use them as dumping grounds for securities they couldn't sell to retail investors and as make-work jobs for well-connected insiders who have nothing better to do for a few years.

Structured notes and principal-protected notes are just as dumb.  They represent positions on a given sector or theme that knowledgeable investors can execute themselves with option strategies.  Credit spreads and collars on ETFs are a whole lot cheaper than some note underwritten by an investment bank.

Proprietary products IMHO accomplish two functions very much in the interest of brokerages.  They tie a client's assets to one firm and tie a broker's book of business to one firm.  Think about it.  A client who is dissatisfied with a broker and wants to move assets elsewhere won't normally be able to transfer the brokerage's proprietary products.  They must be liquidated, incurring a capital gain, if the client wants to move all of their assets.  This sets up the client for a very discouraging conversation with their existing wealth manager:  "Oh gee, you can't move all those structured notes I sold you because the gains will mess up your asset allocation.  You can't move your hedge funds either because you're locked in for five years."

A broker who wants to jump to another firm will face similar hurdles if she or he sold a bunch of proprietary stuff to a significant number of clients.  The top-producing big shot who just had their gross payout reduced will have to think hard after realizing that proprietary products aren't portable from one firm to another.  They are a crude form of "sticky" money that stays with a firm regardless of a broker's customer service skills.

Smart investors ignore sales pitches for the in-house favorite funds and notes.  They cost a premium, which firms and salespeople like to collect, but add little to a well-diversified portfolio (i.e., large and small caps, laddered fixed income, hard assets, etc.).

Smart brokers ignore the internal bonuses paid for sales of proprietary products.  They keep their books of business portable by focusing on widely held fund families and individual securities that any brokerage can hold.

I used to be stupid about proprietary products but I eventually got smart.  I have not owned proprietary products since 2006.  I tried to sell them to prospects when I was a financial advisor in 2005-2006; no one bought them from me.  One prospect even ran away screaming when I described how a principal-protected note worked.  I learned about structured notes' stickiness the hard way when I moved my assets from the full-service firm that fired me to a discount brokerage.  The structured notes wouldn't move until I sold them.  They netted out to just about zero gain after transaction costs.  I will never invest in proprietary products again.