Monday, June 01, 2015

Stock Brokers: Facing Creative Destruction?

“I set out to become the greatest lover in Vienna, the greatest horseman in Austria, and the greatest economist in the world. Alas, for the illusions of youth: as a horseman, I was never really first-rate.” Note the enigmatic peculiarity of that statement. Is the author bragging that he succeeded in attaining the other two goals, or he is just being modest in claiming specifically that he did not attain all three?

About ten years ago (November, 2005) I wrote in Viewpointe the following about the economist Joseph Schumpeter (1883-1950), the author of the above statement: “Although there have been many drastic changes in our lives since then [alluding to an earlier article about Schumpeter], what has remained constant and unchanged is Schumpeter’s major contribution to the theory of economics, and its relevant application to today’s world. In fact, not many years ago, Business Week and the Wall Street Journal were so impressed by his revelations that the former once dubbed him ‘Today’s Hottest Economist’, and the latter (agreeing that he had achieved one of his goals), citing him as ‘the most important economist of the 20 th century.’” (Knowledge of his romantic conquests remains undisclosed.)

Unless you are interested in the field of Economics (as I was as an undergraduate Economics major), it is probable that the presumptuous Mr. Schumpeter is unknown to most readers, yet he is considered a giant in the history of economic thought. Why is he so important? While Capitalism as an economic system has its flaws and is thus not perfect, it seems to have served many countries quite well. What Schumpeter did was to be the first to advance the concept (in a 1942 book) that the engine that drives the growth of Capitalism can be attributed to what he termed creative destruction.

Schumpeter argued that innovation by the entrepreneur, leads to gales of “creative destruction,” as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not “how capitalism administers existing structures, ... [but] how it creates and destroys them.” Thus, creative destruction, he believed, “causes continuous progress and improves the standards of living for everyone.”

While that concept is now more than 70 years old, a more modern version has evolved. The term disruptive technologies was coined by Clayton M. Christensen a professor at Harvard Business School as introduced in his 1995 article, Disruptive Technologies: Catching the Wave.

Two years later the theory of disruptive innovation was invented by Clayton Christensen in his book “The Innovator’s Dilemma”. In 2011 and again in 2013, in a poll of thousands of executives, consultants and business school professors, Christensen was named as the most influential business thinker in the world. As a result, he is considered the architect and the most famous expert on the subject.

If Schumpeter were still alive, I think he would point out that there are more distinct similarities between these two economic theories than there are differences. In fact, there is a video of Christensen admitting to that. As a result I am puzzled as to why Christensen has received that much acclaim for merely re-titling the basic elements that Schumpeter inspired.

The Princeton Professor

Apparently the authors of a recent (May) article on the OPINION page of The Wall Street Journal would agree with that sentiment since they used Schumpeter’s version in this headline: “Creative Destruction at a Broker Near You.” Of the two authors, one cannot be taken lightly. Burton Malkiel is a professor of economics at Princeton University, a two-time chairman of the economics department there, and was dean of the Yale School of Management.

He is most famous for his classic finance book A Random Walk Down Wall Street. I first wrote about that book in 2001, and again in 2003, emphasizing Professor Malkiel’s belief in portfolio diversification; and as a leading proponent of the Efficient-Market Hypothesis which contends that prices of publicly traded assets reflect all publicly available information. He has also been closely associated with the Vanguard Investment Group, and is a strong advocate of index funds.

The Fiduciary Factor

It is therefore not surprising that he foresees a heretofore common broker practice as falling victim to creative destruction. Here are Professor Malkiel’s own words: “Technology is fundamentally altering the investment landscape, and it may have a profound influence on the quality of service that individual investors receive. This change also is relevant for evaluating the controversy currently roiling the securities industry.” He refers to the fact that the vast majority (some 275,000) of those providing investment advice such as stock brokers, are not required to uphold the legal standards of a Registered Investment Advisor (some 15,000) who acts as a “fiduciary.”

The DOL Acts

But it appears that after five years of study, the Department of Labor (DOL) announced in April a proposed amendment to the definition of “fiduciary” under the Employee Retirement Income Security Act. The rule would impose a strict fiduciary standard on those providing retirement advice to individual retirement account (IRA) holders, and also clarify and add to existing standards for advisers to 401(k) and other retirement plans. Here is Malkiel’s explanation:

“In short: Anyone who receives compensation for providing retirement advice must put their clients’ “best interest” first, as opposed to recommending products that are deemed to be broadly “suitable” but that compensate advisers more than competing low-fee investment funds. (My underline.) While it might seem obvious that investors deserve advice that puts their interests first, the proposal has engendered a storm of protest.”

Who are the protestors?––Every stockbroker, every brokerage house, every mutual fund company, and their lobbyists (with the exception of Vanguard that already adheres to fiduciary status). Malkiel continues, “The guiding principle of the Labor Department’s proposal is absolutely correct and long overdue. All too often investors in retirement plans pay higher fees than they should, and their accounts contain high-cost funds that reward the provider of advice rather than the client.” But suppose you could obtain fiduciary advice, low fund expenses, and in addition, significantly lower fees for that advice?

Technology Rules

Professor Malkiel maintains, “Technology will upend the current brokerage model.” Here is how he foresees this happening: “Over the past few years a number of software-based, automated investment advisers have been established, and they are growing rapidly. Firms such as Future Advisor, Rebalance IRA, and our own firm, Wealthfront, [Malkiel is Chief Investment Officer] now provide low-cost, high-quality alternatives to antiquated investment models. Even large traditional incumbent firms, like Charles Schwab and Vanguard, are investing heavily in technology to provide high-quality, fiduciary service to small investors.”

He goes on to explain: “These automated investment services are able to provide sophisticated portfolio management to small investors at incredibly low cost by leveraging the same type of technology that has helped companies like Facebook and Google scale to billions of users. Some automated advisers will even manage accounts of less than $10,000 without charging any advisory fee. Accounts over $10,000 might pay a management fee of only 25 basis points (one quarter of 1%), a fraction of the typical 1%. that traditional investment managers charge.”

How it’s Done

He then describes the investment protocol: “Investments are made in portfolios of low-cost, exchange-traded index funds tailored to the needs and risk tolerance of the client. No trading commissions are charged, and conflicts of interest can be avoided. If we are in an era of future low-gross investment returns, as many investment managers believe, rock-bottom fees are especially important.”

He summarizes as follows: “The securities industry is correct to worry that a strict fiduciary standard is likely to result in massive changes in traditional ways of doing business. Business models that depend on selling high-cost, low-value proprietary products to clients will be threatened, with the result that there may be fewer broker-dealers and investment advisers to choose from. But the best firms will invest heavily in the technology to better address the needs of small investors. Investors will pay less, not more, for the services they receive, and what they get will be better, not worse. Capitalism has always involved a painful process of creative destruction. The financial-services industry will be stronger and more effective because of innovation, and the fiduciary standard will accelerate the process of changing outmoded and ineffective financial business models.”

Perhaps in this case Clayton Christensen’s theory of disruptive innovation might have made a better and more accurate headline.


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