ETF Investing Guide: The Quirks of Market Segmentation

The suggestion that wealthy investors could considerably boost their returns by ditching high net (financial) worth services and instead managing a portfolio of ETFs in an online brokerage account themselves runs totally counter to the currently accepted wisdom of the financial industry. Full service brokerage firms are shedding “low-end” customers or moving them to call-center based services, and focusing on wealthy customers. Merrill Lynch, for example, oversees about $300 billion of assets from clients with over $10 million in their accounts, and probably about a third of the $1.1 trillion in assets in its Private Client Group belongs to clients with over $1 million in their accounts. In contrast, E*Trade, has an average account size of under $20,000, despite the fact that the firm has outside insurance for up to $50 million per brokerage account.

Yet most wealthy investors, we’ve seen, could slash their costs and boost their returns by switching to an ETF portfolio, assembled and managed in an online brokerage account. Furthermore, E*Trade offers what is probably a wider range of fully integrated online banking, lending and brokerage services than the full service brokers, and now has one of the largest ATM networks in the country. So why aren’t wealthy investors switching? I think there are 4 reasons:

1. ETFs are relatively new and are under-marketed. In the short time that they’ve been around, ETFs have been spectacularly successful. But most of that success has been with fast-trading hedge funds looking to manage their long or short sector and market exposure. Since ETFs have low expense ratios, there’s relatively little money available to market ETFs to individual investors. The major mutual fund companies, in contrast, can afford to market their funds heavily due to the far higher expense ratios on actively managed funds.
2. Online brokerages have marketed themselves to frequent traders rather than mainstream investors. Online brokerages make money from trading commissions (they don’t charge asset-based-fees), so they have naturally targeted active traders. That has sent completely the wrong message to mainstream investors, who now view online brokerages as suitable only for day traders.
3. “Full service” brokerages have exaggerated the need for advice while downplaying the effective price they charge for it and their lack of objectivity. You may need financial advice, for example about saving for retirement and education, and estate planning. However, I don’t believe you need much advice about portfolio construction and management. If you’ve read this far, you’ll be able to construct and manage a diversified portfolio of ETFs, irrespective of size, without further help and with relatively little time commitment. And for the areas where you do need advice, there’s a lot of useful information on the Internet and in books. But many “full-service” brokerages seem to suggest that life is far more complicated, and you really need ongoing advice. At the same time, they downplay the fact that their advisors are plagued with fundamental conflicts of interest, and they often avoid clear disclosure of total fees charged - the cost of the advice they provide.
4. The Internet is relatively new, and many wealthy individuals are only gradually becoming comfortable with it. This has worked to the advantage of full-service brokerage firms. The Internet enables easy price comparison, and offers ample information about financial products and services. Internet savvy investors can quickly compare the performance and fees of actively managed mutual funds with ETFs, and can easily compare the fees charged by brokerages and the yields on bank and money market accounts. As a result, full-service brokerages have promoted the broker-centric model and downplayed the convenience and power of Internet financial services. Since many of their wealthy clients are at the peaks of their careers or retired, and are only gradually becoming comfortable with managing their finances online, this strategy has worked.

In sum, online brokerages and index funds are considered appropriate for day traders and less wealthy customers, while full service brokerage, managed accounts, and asset-based-fee services are considered appropriate for the wealthy.

What a mistake! It costs the same to purchase 10 shares of an S&P 500 ETF worth about $800 as it does to purchase 5,000 shares worth $400,000 in an online brokerage account. So the savings of the ETF/online brokerage approach grow proportionately the wealthier you are. If only they knew…

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