Economics

How Wall Street Turns Their Variable Expenses Into your Fixed Costs

As a business major, one of the first things I was asked to wrap my head around was the difference between fixed and variable expenses.

Simply put: Fixed costs and expenses accrue regardless of business revenue. Included are rents, interest, basic utilities, the Keurig, depreciation, insurance, government charges, and executive salaries. There is only one (legitimate) fixed overhead item in a managed investment portfolio.... the management fee.

Variable expenses occur as you attempt to produce revenue. They include employee salaries, office supplies, K-cups, utilities, marketing, inventory control, etc. There is just one (legitimate) variable expense in managing the inventory within an investment portfolio... commissions.

Business revenue must exceed both forms of expenses for the firm to remain viable; in investing, the variable expenses are included in the cost basis of securities owned; fixed expenses are not. If your total realized portfolio earnings exceed the management fees, you are operating profitably.

Higher variable expenses decrease portfolio yield slightly, raise the selling price at which reasonable, targeted, profits can be taken, AND they increase the dollar profit of each trade. Fixed costs are direct deductions from working capital... similar to paying property taxes, tuition, & travel expenses by selling securities.

The key to business success is the minimization of the fixed expenses and control of the variable ones. This is why most "startups" start up in garages and basement offices, why entrepreneurs rarely pay themselves salaries for several years, and why businesses in general fight so hard to avoid government mandates that impact their cost structures.

In personal portfolio management, rising fixed costs (i.e., management fees, SEC assessments, custodian fees, etc.) are direct withdrawals from your investment wallet. Higher variable expenses (commissions and service fees), while increasing cost basis, have no direct negative impact on either market value or working capital.

Wall Street is very good at channeling the costs of regulatory oversight into increased fees for you and me... they reduce their fixed costs by increasing our variable expenses, and in some instances, our fixed costs as well.
Wall Street firms shift compliance and other government related costs to their customers in the form of transaction fees and service charges.

All of these excessive (sometimes punitive) transaction charges are assessed with the knowledge, approval, and assistance of the regulatory agencies... BUT that's only the "cake".

The "icing" is the subtle way in which the institutions have covered their variable expenses through the fixed revenue stream they exact from "managed account customers". Perhaps the sickest example of this is the "Wrap Account", where the managed account is simply a "one size fits all" mutual fund, where every participant has a proportionately identical portfolio.

Not only have they brainwashed the American investor (great book title), they have also hypnotized the regulators... hmm, are lobbyist activities considered fixed charges, variable expenses, or just plain graft?

Way back in 2007, an executive in the "managed money" department of our major full service brokerage firm invited himself to my "operation" in South Carolina. We talked about investment strategy, my disciplined trading style, and their select group of private account managers.

He  was afraid that the ROA (Return On Assets) of our individual client, commission based, personal portfolio approach, would raise SEC eyebrows, and he was quite clearly trying to coerce us into moving our entire book to their fee based programs.

ROA compares the amount of trading commissions generated with the size of the portfolio... profits on the trading aren't even considered. Anything over 3% could incur the wrath of the regulatory gods... even if the resultant net/net profit was in the 7% to 10% target range.

MCIM (Market Cycle Investment Management) operationally speaking, the more total commissions a disciplined trading approach generates for the broker, the more net/net total profit is being generated for the client. You should repeat that.

Isn't regulatory "math" fascinating? Today, the DOL is telling 401k plan sponsors that the "internal" costs of an investment product are more important than the amount of income the product produces... 1.85% income after .35% in fees is somehow better than 6.50% after "internal" fees of 1.85%.

"Ya see Steve", the managed money guy had the 'bollocks' to say in front of witnesses, "we make a lot more money, with a lot less potential liability and actual overhead, when we work on a flat fee basis."

Today, compliance executive "interpretation" of the regulations is pressing for all accounts to be fee based... commissions, eventually, will not be an option in managed portfolios. Management itself may not be an option in small portfolios, where logic tells us it is most needed.

But, somehow, commissions are still OK in those portfolios... the "house", after all, always gets its "get".

Compliance officers have no "bollocks" at all. They dictate counterproductive policy to avoid confrontation with regulators, and in doing so, have managed to turn variable expenses into fixed portfolio overhead... and a guaranteed annual revenue for "The Masters".

Those creative folk in Wall Street executive suites are ROTF-LOL, as the regulators force investment managers to charge clients 3% per year, whether or not any trading takes place.
No, the 3% doesn't include the fees within the products that populate most managed programs... and you still pay services fees, SEC and Custodian fees... now that's "bollocks"!

I once had the frustrating experience of explaining the difference between fixed and variable expenses to an SEC "it's da law" inquisitor. She was certain that my clients were being ruthlessly overcharged by the "advisor fee plus trading commissions" arrangement that was our standard way of doing business. What about this math is so difficult to understand?

If I make a $100,000 investment in securities, including the commissions (cost basis = $100K) and sell the whole bunch for $110,000 after paying the selling commissions, the net/net profit is 10%. (One trade or 100, it makes no difference.) After an 0.8% annual management fee, the gain is $9,200, a 9.2% gain in Working Capital.

If I do the exact same activity with a regulator acceptable flat fee of 3.00%, my final Working Capital is $107,000.

What if there were no trades at all? Commission approach = $99,200 remaining at year end; Flat Fee approach, $97,000.

So, when is the client the beneficiary of a flat fee arrangement? Absolutely never, and the "institution" always takes more than 3%, regardless of trading activity or performance.

This is the (criminal) genius of Wall Street. They have brainwashed investors, investment professionals, and the regulators into believing that it is the variable expenses that need controlling, not the fixed costs of running the portfolio.... just ask Charles Schwab.

As if this isn't enough, most "One Flat Fee Only" customers are punished with an assortment of service and custodian fee assessments that should turn regulator faces red with anger or embarrassment... and absolutely no one can tell you precisely what the "base" service fee is for.

It's time you took a closer look at your electronic confirmation notices, and raise some questions.  The service fee varies from $3.95 per trade to as much as $7.50; the discount brokers charge somewhere in between... but that is the subject of the next article.

Yes, there is a relatively simple (and "fair to all concerned") solution, but the Wizards wouldn't be able to steal quite as much of our hard earned.

They (the institutions) should be required to hold fixed expenses (management fees) to 2.5% per year, but they must include all service fees, SEC fees, handling charges, whatever... yes, there needs to be a lower fee for income purpose portfolios.

As to the variable expense we call commissions, lower would be appreciated, but rates based on order size and dollar amount just have to be outlawed... one magic flat fee for all standard (broker assisted) trades... nearly all trades are done electronically these days. How much does it cost to hit a button on a computer screen?

AND, the ROA display of regulatory ignorance? Replace it with a rule that limits the commission to 25% of normal on the 1st five short term losses (after commissions), and to 0% afterwards.

Next in the Class Action Suit series: Wall Street Institutions & Regulators, The "Penny" Parasites

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