The Bonfire of the Intermediaries

We've heaped a lot of criticism on the dominant model of the financial services industry in the past, a model which we call "The Intermediary Trap."

We believe that the current system, which separates investors from their money managers and interposes an intermediary between the client and the manager, leads to performance which can be far worse than the performance of the overall market. Numerous studies back up this argument.

Let's pause, however, and consider for a moment the unfortunate plight of the intermediaries themselves, at this particular juncture in history.

For an entire generation now, entrants into the financial services industry who deal with investors have been told that they don't need to pick stocks (or other individual securities) but instead their role is to gather assets and to farm out the management of those assets to a variety of "professional" money managers. In other words, they don't pick individual securities: they pick managers (by picking mutual funds, or index funds, or exchange-traded funds, or separate portfolios, or some combination of all of them and a few others as well).

A large percentage of these intermediaries are reeling right now. They "diversified" their clients into a host of different areas, including international investments, commodity-based investments, and even "alternative investments" (such as hedge funds, managed futures, and other exotic products). They followed the modern portfolio theory advice that helped create the intermediary system to begin with, and in many cases their clients' investments are now down considerably; in some cases well in excess of the general market averages which they were so carefully designed to outperform under multiple scenarios. With this disastrous last years' performance and the horrendous long term performance noted in the studies referenced above, we can only imagine how many of these intermediaries (and their investors) must feel right now.

We have always maintained that the majority of intermediaries honestly try to do their best by their clients, and that the damage that is caused by the intermediary system to the investment returns of the actual investors is usually the result of good intentions. We've explained how these good intentions can lead to the intermediary chasing what has been doing well lately, for instance in "Investor behavior . . . or Advisor behavior?" and other posts that are linked in that piece.

Now, however, after a year that decisively showed the flaws in the system that they had relied on for their entire careers (some of them for decades), the intermediaries don't know which way to turn. They know that something needs to change, but they have not been equipped to know exactly what.

We would offer the advice that the way forward has always been there.

The severe bear market of 1973-1974 was the impetus that moved the investment world away from the world of "practical operators in the stock and bond markets" and into the world of "academics with their mathematical stochastic models," a move which led to the rise of the intermediary system we have today. The carnage of 2008 provides an opportunity to return to the path that many abandoned after 1974 -- the path of reliance upon investment in businesses through ownership of individual securities, as we have discussed many times on these pages (see here and here, for example).

The advantages of doing so are enormous. They are most important, perhaps, during tough times. Because of our approach, we know exactly why we own every single security in the portfolios that we manage for our clients. That is something that is almost impossible to achieve operating under the intermediary system.

It is a message that we don't want to keep to ourselves, but share with the world, because we believe it is a message that is particularly critical right now.

For later posts dealing with this same topic, see also:

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.


Post a Comment