A Reformed Broker Exposes Wall Street

January 14, 2008

Michael Lewis tells a wonderful story in the new Portfolio magazine – a coming of age piece if you will – of a successful stock broker who slowly realizes the (ahem…) shortcomings of his business.

‘Seven months in at Lehman, I was one of the top rookie producers,’ Blaine says, ‘but every stock I bought went down.’ His ability to be wrong about the direction of an individual stock was uncanny, even to him. At first, he didn’t understand why his customers didn’t fire him, but soon he came to take their inertia for granted. ‘It was amazing, the gullibility of the investor,’ he says. ‘When you got a new customer, all you needed to do was get three trades out of him. Because one of them is going to work. But you have to get the second one done before the first one goes bad.'

It wasn't exactly the career he’d hoped for. Once, he confessed to his boss his misgivings about the performance of his customers' portfolios. His boss told him point-blank, ‘Blaine, you're confused about your job.’ A fellow broker added, ‘Your job is to turn your clients' net worth into your own.’ Blaine wrote that down in his journal."

The story first attacks the notion of beating the market with stock picks then moves on to picking wining mutual funds:

SmartMoney’s cover story ‘Seven Best Mutual Funds for 1996,’ whose selections later underperformed the market by 6.7 percent. In 1997, SmartMoney found seven new best mutual fund managers. They finished 3.4 percent below the market. In 1998, the magazine’s newest best funds came in 2.2 percent below the market. Soon after, Wellington says, ‘SmartMoney stopped its annual survey of the best mutual fund managers.’

Eventually our hero moves his clients and his conscience to Dimensional, proprietors of the successful DFA (which stands for Dimensional Fund Advisors) funds.

DFA, an early pioneer of low fee index funds, has $152 billion under management. Unlike Vanguard, DFA does not have actively managed funds or ETFs. DFA indexes are not just market cap weighted or based on well known indexes like the S&P 500, Nasdaq, or Russell 2000, but involve custom screens that remove some individual holdings that would ordinarily show up in a straight market cap screen.

DFA funds are institutional funds sold though advisors, who tag their own fees on top of the underlying fund fees.

In addition to learning some great sales techniques used to con prospective brokerage clients into paying full service commissions for stock bad stock picks, the article focuses on the benefits of low fee indexing over more expensive and inconsistent active management. What the article doesn’t do is question the logic of dozens of different asset classes – too much of a good thing perhaps.

If a broker’s stock picks tend to underperform broad indexes, why won’t an advisor’s sector or style picks using DFA funds do the same?