The Bear’s Lair: High Net Worth Retail – Everybody’s Suckers

I am glad I am not rich! If I were, I would be subjected to bombardment by the financial services sector, attempting to sell me fancy products just when they are going out of style. The plumbing of financial services is very apparent: as far as possible you want to get to the source of deals and stay well away from the elegantly dressed salesmen who deal with the rich. Maximizing your return is simply a matter of maneuvering yourself further up the food chain.

The low position on the financial services food chain of high net worth individuals has been apparent since the days of the Great Gatsby. The young, callow Nick Carraway has the job of selling bonds to wealthy individuals; it is clear that he is neither likely to get rich by doing so nor close to the share deals and “pools” that were the epicenter of Wall Street’s activities at that time. While smaller retail investors did not invest significantly in the stock market except at the very peak of 1928-29, the very rich (below the true titans) were already sufficiently large sources of brokerage fees to be worth cultivating, without being sufficiently important to be let in on the big deals.

The position of wealthy individuals worsened further after World War II, with the rise of the institutional investor. These became an important factor on Wall Street in the 1960s, where they formed a powerful lobby for deregulation of brokerage commissions – 1% on an institutional sized ticket was a truly excessive amount of money to be deducted from the institution’s clients and given to its broker. In European markets, this was still true in the early 1980s; a clever young acquaintance of mine at Morgan Stanley was given the normal retail brokerage percentage of fees earned and assigned to sell Scandinavian equities; by focusing on the institutional market he made over £7 million in his first year, a truly fabulous amount at that time, and bought a major Oxfordshire country house with the proceeds.

The pecking order on Wall Street is now crystal clear. At the top, naturally, are Wall Street insiders themselves; the Goldman Sachs partners and others who actually originate deals, getting small but lucrative percentages thereof to bolster their investment performance.

Next are the hedge funds and private equity funds, sources of massive fee income to the Wall Street deal machine, and major originators of deals themselves; they will get the richest slices of the cake, as rewards for services rendered, past and future.

Next are the important people that Wall Street needs to keep sweet; they may be politicians with substantial investment portfolios or CEOs of companies that provide Wall Street with significant deal flow (companies that, while important, do not do many deals are well to the back of this line). These people get preferential treatment and advice — at least sufficiently so to keep them sweet – though they are a lower priority than those whose investment outcomes are truly important to Wall Street.

Next, and the largest group, are the institutions. By and large, Wall Street is careful about not palming off scams and rip-offs on the institutions, because they have lawyers. Conversely, Wall Street spends a great deal of effort persuading institutions to accept non-standard products, such as derivatives, private equity, real estate and hedge funds, for which the pricing is opaque and Wall Street can thus make more money. Fees on hedge funds and private equity are notoriously generous, yet, given the amounts of money now devoted to them, there is little reason to expect gross returns to be any higher than on public equity. A pension fund who is paying “2 and 20” (2% of the amount invested plus 20% of the profit on the investment) for a private equity or hedge fund investment is thus ipso facto violating its fiduciary responsibility to its pensioners.

Small-scale retail investors are next on the list, but not bottom on it. That is because the regulators, the SEC and others, are politically motivated to ensure that small investors are protected from scams. From the titans of Wall Street, small investors will not individually get any favorable deals, but they will not get gratuitously ripped off, in the way they were in the 1920s before the days of securities regulation. That is a small mercy, but it is a mercy nonetheless. In addition, through pooled investments, small investors have the opportunity to participate alongside the institutions, at a cost of only modest management fees. This is probably their best way to wealth, provided they can avoid second-guessing the institutions on market timing and adopt a buy-and-hold attitude.

(The institutions will generally be no better than random on market timing, but small investors will generally be considerably worse, because they are deluged with commentary from journalist writers on the markets, who are at best ignorant and often latecomers on every senescent trend – as my splendid first boss once said in respect of a market newsletter which I had been late to read; “It’s the International Outsider by the time it gets to you, Hutchinson!” In particular, small investors notoriously get over-excited in market bubbles and panic in market slumps; they cannot help it, since they are deluged with amplified information leading them in the wrong direction.)

That leaves wealthy individuals, often wealthy enough to have private offices managing their investments, but not true “movers and shakers” in the global economy. They are more annoying and difficult to deal with than institutional investors (though large private offices are essentially institutional in nature). On the other hand, they are “sophisticated investors” whose accounts are large enough that Wall Street can sell them high-margin products without political or SEC repercussions. They are a long way from the deal flow yet represent a pool of money that is well worth tapping.

This makes a huge difference to their returns. As one example, the Harvard Business School Club of New York City, which collectively represents a simply stupendous pool of money together with unrivalled self-confidence as to its own financial sophistication, operates a venture capital “angels” network, the HBS Alumni Angels of New York, which claims to be the largest “angel” group in New York. That’s all very well, but the start-ups in which I would want to invest would tend to have scientific geniuses involved, not Harvard MBAs, and there is no reason to expect the HBS Alumni Angels to have extraordinary access to such people and their deals. Thus, an extraordinary pool of money, an extraordinary level of competition within the pool’s providers for such deals as arise, but limited access to deals is a poor combination for outsize returns. In the tricky field of venture capital, I want to go somewhere where there are more deals and less investment capital.

We are now told that the market for “alternative” investments – hedge funds, private equity and real estate – among institutional investors is saturated, since those institutions typically have around 30% of their funds invested in such assets. While the returns for the last decade have been excellent — the California Public Employees Retirement System estimated this week that it has missed out on $18 billion of gains by pausing private equity investments since 2009 – I would argue that the excess returns have been a product of “funny money” and leverage and can be expected to go into reverse now that interest rates are finally, blessedly rising.

We are also told that Wall Street is looking to wealthy individuals as the new market for these exceptionally lucrative – to their sponsors – investments. Those wealthy investors should check the locks on their wallets. For one thing, we are advised by Mikkel Svenstrup, chief investment officer of Denmark’s largest pension fund, that private equity “may become a pyramid scheme” since private equity funds, in the difficult markets of 2022, have taken to selling their private equity investments to each other, or even to other funds within the same group, naturally reporting large capital gains each time they do so.

It appears to me that in this new world of tighter money and falling markets, the flaws in the alternate investment universe may well be about to appear in profusion. Wealthy individuals should thus be exceptionally skeptical not to say hostile when their broker calls them to offer a special “insider terms” deal. As on every occasion since the Great Gatsby era, they are almost certainly being played for suckers, by smarter investors looking for the exits.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)