March 2014 Investor Letter Ben’s Notes by Ben Strubel

In this months newsletter I’ll be running the financial industry in to the ground. Before I want to make the point that what I’m about to say doesn’t apply to everyone in the industry. While the average mutual fund, broker, wealth manager, and hedge fund charges high fees and delivers poor results it doesn’t apply to everyone. I know lots of good, honest hedge fund managers that charge reasonable fees. I know lots of wealth managers that act in their clients best interest and don’t gouge them on fees. Unfortunately these are the exceptions rather than the rule.

With that caveat out of the way, let’s begin.

Over the past year or so, the issue of rising income inequality in the United States (and even worldwide) has come front and center. Most of what I’ve read has focused on wages, union membership, unemployment, taxation, government subsidy, and executive pay issues.

There is one issue whose role I think is overlooked: the role the financial sector plays in exacerbating income inequality. In fact, the financial sector is one of the prime causes, and at its current point is perhaps the greatest parasite in human history. It is sucking wealth from the productive sectors of the economy at an unprecedented rate.

Before we go any further, I want to define the term “income inequality.” When I use that term, I am referring to the fact that, on average, the incomes and standard of living of American workers is not keeping pace with productivity. I’m also using the term, in part, to explain why workers and executives in some parts of the economy are overpaid in relation to the benefits they provide. What I am not doing is making a blanket statement that money should be taken away from successful, hardworking people and given or “redistributed” to the lazy.

The Role of the Financial Sector

In economics, the financial sector is typically lumped in with the insurance sector and real estate (the financial portion of the real estate sector, not construction) sector. Together, the sectors are often abbreviated and called the FIRE sector. In this article I will talk mainly about the finance portion of the FIRE sector since it is by far the largest, most visible, and most corrupt.

The problem is that the financial, insurance, and real estate (FIRE) sectors do not actually produce any goods or services. If you go on Google Inc (NASDAQ:GOOG) Finance you’ll see it divides the economy into ten sectors: energy, basic materials, industrials, cyclical consumer goods, non-cyclical consumer goods, financials, healthcare, technology, telecommunications, and utilities.

The nine nonfinancial sectors all produce goods or services. For example, the energy sector companies drill for our oil and refine it into gasoline (e.g., Exxon Mobil Corporation (NYSE:XOM)); the basic materials sector mines our iron (BHP Billiton Limited (NYSE:BHP)) and refines it into steel (Nucor); the industrial sector produces the mining equipment (Caterpillar) used by the previously mentioned sectors; the cyclical consumer goods sector produces our cars (Ford Motor Company (NYSE:F)) or sells our everyday items (Wal-Mart Stores, Inc. (NYSE:WMT)); the non-cyclical consumer goods sector sells the things we need no matter what, such as groceries (Safeway Inc. (NYSE:SWY)); the healthcare sector provides the medicines that heal us (Johnson & Johnson (NYSE:JNJ)); the technology sector gives us the computers and software we use (Apple Inc. (NASDAQ:AAPL)); the telecommunications sector gives us the ability to communicate (Verizon Communications Inc. (NYSE:VZ)); and the utility sector gives us the power to run our homes and businesses (Duke Energy Corp (NYSE:DUK).

The financial sector? Well, according to Harvard professor Greg Mankiw, chief academic apologist for the financial sector, this is what it’s supposed to do:

“Those who work in banking, venture capital, and other financial firms are in charge of allocating the economy’s investment resources. They decide, in a decentralized and competitive way, which companies and industries will shrink and which will grow.

The job of the finance sector is simply to manage existing resources. It creates nothing. Therefore, the smaller the financial sector is the more real wealth there is for the rest of society to enjoy. The bigger the financial sector becomes the more money it siphons off from the productive sectors.

The graph below shows how the financial sector has grown since 1960. The figures are shown as a percentage of investment (using both gross and net investment).

Financial Sector

(Graphic source: Jacobin Magazine)

As you can see, the financial sector has almost doubled or tripled in size since 1960. That means it is extracting double or triple the amount of money from the real economy!
Just how much?

I want to go through several areas of the economy to show you how the financial sector is extracting money and offering no benefit.

The Grift in Your Retirement Plan

I want to start with the industry I work in, wealth management. When I started my business, I was cognizant of how investors were ill served by the traditional model of wealth management. I am thankful that with technology and some hard work I am able to provide institutional-quality (meaning, I make direct investments in securities for clients) wealth management at a total cost of 1.25% to 1.30% of assets per year (plus a $25 to $50 charge for retirement accounts). When I say “total cost,” I mean just that. The figure includes all fees I charge (including both for investing and financial planning), the brokerage or custodian fees, trading costs, plus the costs of any underlying funds (if any).

Unfortunately, a vast majority of the financial industry has built an unrivaled apparatus for extracting huge sums of money from retirees and mom-and-pop investors.

Say, you’re sitting on your couch, watching TV and thinking about retirement. You just got part of your inheritance and think investing it for the future would be a sensible idea. Imagine you haven’t the slightest idea how to get started. Then a commercial comes on with Tommy Lee Jones telling you how trustworthy Ameriprise is. Maybe you hear the reassuring voice of John Houseman pitching Smith Barney, or you might see the iconic bull charging across the desert for Merrill Lynch.

Say you decide to go down to your local brokerage and meet with a financial advisor. His (or her) pitch sounds good, so you decide to become a client.

The first problem is the guy you met. Remember how he told you he has his finger on the pulse of the market, he has access to the best investment research, he is always taking continuing education classes, and he is always monitoring your portfolio? He isn’t. He could be a complete moron. He got hired (and survived and thrived) because he is a good salesman. Nothing less and nothing more. He takes his orders on what to sell from the top — the gaggle of people with their fingers in your retirement pie, helping themselves to regular bites.

The first person behind the scenes telling our hapless salesman what to do is some sort of office, district, or regional manager. This is manager is just like the salesman but with more ambition. Almost all of these guys were promoted from sales, and their job is do an impersonation of Alec Baldwin from Glengarry

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