by Key Points
- Many revere Wall Street for its ability to provide its clients with superlative (better than the market average) risk-adjusted returns.
- Nevertheless, fees, one way or another, are the fundamental driver of Wall Street’s success.
Follow the Money
Its. All. About. The. Fees. In 2017, the average yearly bonus on Wall Street topped $182k. According to the Washington Post, that’s more than three times what most U.S. households made all of last year. So what’s Wall Street’s secret?
You may not have heard of Willie Sutton (1901-1980), but you have likely heard of his famous catchphrase. Sutton was born in 1901, and he was a bank robber by profession. Over his career, it is estimated that he made off with over two million dollars in bank robberies across the United States. By nature, he was a quiet and reserved, but he was also very smart and cunning.
Nevertheless, Sutton was caught many times, he escaped many times, and he spent much of his life in prison. But ultimately he was paroled in 1969, at which point he lived out his days as a minor celebrity. And as the story goes, one reporter famously asked him, “So Willie, why do you rob banks?” Sutton’s answer was plain and simple:
“That’s where the money is.”
According to Snopes, Sutton argues that he never said this, but nevertheless, you may still get my point. So, why are the bonuses on Wall Street so large? I suggest we look to Sutton’s catchphrase for insight.
Nothing to Hide Here
You might think the secret of Wall Street is its ability to provide its clients with superlative (better than the market average) risk-adjusted returns. But in fact, it’s not. The secret of Wall Street is fees.
For example, investment banks collect fees by helping firms list their stock on public stock exchanges (going public). These same banks collect fees by helping these same firms delist their stock from public exchanges (going private). Mergers and Acquisitions professionals help larger companies gobble up smaller ones, often with debt structured by banks, and all for a fee.
Then there are retail banks that will happily store your savings and deposits (often providing you with a low or even zero percent interest rate). And of course there are overdraft fees, bounced-check fees, foreign FX fees, ATM fees, wire and transfer fees, and monthly maintenance fees associated with these accounts. These retail backs will then lend out many times that capital in the form of loans at much higher interest rates.
And then there are commercial banks that essentially borrow from your savings and deposits, while paying you a marginal interest rate and then lend to other consumers and business at a higher rate. You can think of this interest rate differential (known as an “interest rate spread”) as essentially a “fee” the bank charges for temporary use of other people’s money.
And of course, there are credit cards, with interest rates so high that the government had to institute “usury” laws to cap how much interest these instructions could charge their clients.
Indeed, fees are no stranger to the investing world when it comes to stocks as well. Traders help their larger clients trade stock, and so can your online broker, all for a fee.
For example, let’s say one of your stocks was down a bunch. Your trader “pal” may encourage you to sell that stock and buy another stock slated to do much better. Your “pal” collects transaction fees, and you get your better stock. But as we’ve mentioned, stocks are priced such that either stock should provide you with the same risk-adjusted return on a go-forward basis; doesn’t your “pal” know this?
Clients can further invest in a collection of stocks, actively or passively in the form of Exchange Traded Funds (ETF) or mutual funds, each with their own fees in the form of expenses; but as you might expect, the fees for these active products are much higher (more on this in Part 3 of this series).
Or for something even more exotic, eligible clients might invest in a hedge fund (with fees for management, performance, commissions, and fund administration) or even a collection of hedge funds, known as a Fund of Funds (with of course, even more fees).
Most of these fees are in plain sight in the form of transaction fees and fund expenses. But as we’ll see later in this series, sometimes other “fees” are not so obvious.
Finally, if these institutions get into trouble by lending out too much (i.e., taking on too much leverage), they can be bailed out by the federal government as we all witnessed during the Great Financial Crisis.
Glorified Casino
This is why Wall Street makes so much money. It’s all about transaction volume; and in between each transition there’s a middle man that collects a fee.
In the world of gambling, this “middle man” is known as a bookie, and bookies make money regardless of who wins; a bookie’s risk is covered if your team beats mine or vice-versa. The same is true on “The Street”, and as I’ve stated before, the house always wins.
But why can this industry command such high fees in general?
When it comes to investment products, you might think the high fees would be for compensation in exchange for better returns to their clients, but this often turns out to not be the case. For insights into this very important point, keep reading. I’m sure you’ll find the analysis presented to be very compelling, indeed.