“Skipping your due diligence and only looking at who has the biggest transition note or highest payout greatly increases the odds that you may in fact need to do this again.”
MINNEAPOLIS (PRWEB) September 29, 2020
In his September 24, 2020, ThinkAdvisor article, independent broker-dealer recruiter Jon Henschen counsels that when financial advisors shop for a new broker-dealer, the thought of bear market vulnerability is rarely on their radar — but it should be.
Henschen’s article opens by noting that there have been eight bear markets between 1926 and 2017. Their duration ranged from six months to 2.8 years, while the severity of the decline varied from about 22% to an 83% drop in the S&P 500.
He comments that the 1973-1974 stock market crash was an especially deep correction, with the market losing over 45% of its value. (The crash came after the collapse of both the Bretton Woods system and the Smithsonian Agreement, causing deep dollar devaluation.)
For broker dealers, the 1973-1974 crash was extremely tough. As Raymond James explains on its website, “During the economic downturn of 1973 and 1974, with the survival of the firm in the balance and capital reserves dwindling, Tom James [sold] off portions of his prized rare coin collection to help keep our doors open.”
Henschen comments on a home office visit to Raymond James more than a decade ago, where a recruiting executive shared that one factor that helped pull the firm out of its financial difficulties during those times was its expansion into the independent channel.
The employee channel is more vulnerable to market shifts, because it is saddled with high branch overhead items, such as leases, branch managers, compliance officers and sales assistants. As broker-dealer revenue drops, these costs remain largely constant.
The independent model, meanwhile, flips this overhead over to advisors, and in exchange they receive much higher payouts — making the broker-dealer more resilient by reducing its overhead.
Henschen cites a research report issued earlier this year during the correction, in which Goldman Sachs provided additional insights into which broker-dealers are more resilient and which are more vulnerable in a bear market. (The day before the report was released, March 23, the S&P reached a year-to-date bottom of 2,237.40, though it’s since recovered.)
According to Henschen, in the report, Goldman Sachs analyst Alexander Blostein downgraded Raymond James to sell, commenting, “The vast majority of RJF’s revenues are cyclical, tied to either equity markets (51%) or interest rates (16%), and are also exposed to elevated headwinds in Investment Banking and Capital Markets/Trading (13%).
These remarks and the related downgrade — which could be applied to many of the wirehouses and regional broker-dealers — contrasted with the report’s assessment of LPL Financial, which was raised to a buy.
The report viewed LPL as a more “pure-play” model, with Blostein expecting the firm’s revenue streams to be relatively immune to elevated market volatility, cash balances likely to spike, and recruiting growth to increase. Part of the expected recruiting boost, the analyst said, could come from smaller advisory practices looking to partner with stronger firms, creating more M&A activity for LPL.
Henschen’s article then shares that his recruiting firm sees small broker-dealers, largely those with fewer than 100 advisors, as especially vulnerable to a bear market and certainly more vulnerable to a downturn in the markets than they were in 2008, in part because a larger percent of their budget now must be allocated to compliance expenditures.
When Henschen’s firm surveyed small- and mid-sized broker-dealers and asked, “What percent of your budget goes to compliance related expenses?” the amount varied from 30% to 50% of their overall budget. When asked, “How has your compliance budget increased over the last five years?” Henschen reports a consistent response: It’s resulted in a 10% increase to the overall budget.
In addition to broker-dealer size, other factors come into play when it comes to areas of potential weakness. Henschen breaks it down as follows:
Financials: Does the broker-dealer have high debt levels? Does it have ample net capital or access to additional cash to prevent a net capital violation? If it is barely profitable in good markets, what happens in a bear market?
Compliance Risk: During bear markets, some clients may want a pound of flesh, so customer complaints mushroom. Is the firm heavily weighted in illiquid investments or investments that have a high litigation risk?
Does the broker dealer’s errors and omission insurance have high aggregate coverage ($2 million minimum and preferably $3 million to $5 million for small- and mid-sized firms)?
FINRA Fines: Does the broker-dealer have a history of poor supervision as reflected by FINRA fines?
A lack of supervision often reveals itself through client complaints during and after a bear market. As Warren Buffett says, “You only find out who is swimming naked when the tide goes out.”
Deep Pockets: Does the broker-dealer have a deep-pocket parent company or revenue silos outside of the broker-dealer? Not being solely reliant on broker-dealer revenue adds a layer of security during difficult markets.
Henschen’s article continues by discussing which types of broker dealers may be the most vulnerable in a downturn and suggests that we may begin to experience difficult times the full article here.
Jon Henschen is founder of Henschen & Associates, an independent broker-dealer recruiting firm located in Marine on St. Croix, Minnesota. With more than 20 years of industry experience, Jon is a staunch advocate for independent financial advisors, and is widely sought after by both reps and broker dealers for his expertise and advice on independent broker dealer topics. He is frequently published and quoted in a variety of industry sources, including WealthManagement.com, ThinkAdvisor, Investment Advisor Magazine, Wealth Management Magazine, Financial Advisor IQ, Financial Advisor Magazine, Investment News and others.