The Ten Roads to Riches

by Ken Fisher

  Get the client.

  Keep the client.

  Do well for them.

  Your income depends on how much in client assets you gather, how well you do keeping clients, and what returns you (or your firm) makes for them.

  Choose your business model—fee-based or commission-based.

  Fee-based is where I started decades ago. It was simple and compelling. I knew if I could gain clients, net of terminations, at rate X percent, and grow their assets at rate Y percent, then my firm would grow at the rate of X percent + Y percent. So gain new net assets at 15 percent a year and grow assets at 15 percent a year—the firm grows 30 percent a year. That’s hot. It’s the Y in the X + Y formula that makes this OPM model so compelling. And my firm has grown at just above 30 percent a year on average for the last 35-ish years. If you can grow any business at 30 percent a year for 25 years without selling stock to outsiders, you end up very rich by anyone’s standards.

  Value the Business

  So is it commission- or fee-based for you? To decide, think like a business owner. Here is an exercise you can use many ways to figure what’s worth what:

  Go to Morningstar.com.

  Search for any stock—a mutual fund like Janus Capital (fee-based) or a wirehouse broker like Merrill Lynch (commission-based).

  Click on the “snapshot” button in the left-hand column.

  Click on “industry peers” (across the top). Note: Whether a company is listed as a peer is up to Morningstar—sometimes the results seem wonky. For example, Merrill Lynch’s industry peers include Goldman Sachs and Morgan Stanley (other brokers), but also NYSE Euronext and Nasdaq Stock Market (exchanges). Ignore the exchanges.

  Make a list of similar companies.

  Divide each firm’s total value (market cap) by sales to create a ratio.

  See who has higher or lower ratios.

  I’ve done this for you as an example. You can do it for any stock. Table 7.1 shows results for mutual funds—fee-based firms. Most fund families have ratios from two to nearly five. Legg Mason and BlackRock are outliers. So the market says these kinds of firms are worth two to five times their annual sales.

  Table 7.1 Mutual Fund Market Cap versus Sales

  Firm Market Cap (Mil) Sales (Mil) Ratio

  BlackRock $59,318 $11,401 5.2

  Bank of New York Mellon $45,269 $15,194 2.9

  State Street $24,892 $10,360 2.4

  Franklin Resources $21,660 $7,949 2.7

  T. Rowe Price $19.027 $4,201 4.5

  Invesco $12,976 $5,123 2.5

  Eaton Vance $ 4,181 $1,404 3.0

  Legg Mason $ 3,557 $2,661 1.3

  Janus Capital $ 2,754 $1,076 2.6

  Source: Morningstar.com as of June 2, 2016.1

  Table 7.2 lists brokerage firms—commission-based. Note lower ratios—many under 2! Outliers are Charles Schwab and TD Ameritrade. (Schwab has a huge mutual fund business and is hybrid fee-based/commission-based.) The market values a buck of commission-based sales half as much as fee-based sales. The upside? Even medium-sized brokers are bigger than almost all money managers. There is vastly more business in the commission-based world, but it isn’t as valuable. That’s your trade-off—more versus more valuable. (Note: Even before Bear Stearns imploded in 2008, it was still about as profitable as its peers.)

  Table 7.2 Brokerage Firm Market Cap versus Sales

  Firm Market Cap (Mil) Sales (Mil) Ratio

  Goldman Sachs Group $66,139 $39,208 1.7

  Morgan Stanley $53,113 $37,897 1.4

  Charles Schwab $39,848 $ 6,501 6.1

  TD Ameritrade $16,876 $ 3,427 5.2

  Raymond James $ 7,710 $ 5,308 1.5

  E*Trade $ 7,628 $ 1,557 4.9

  Lazard $ 4,500 $ 2,405 1.9

  Source: Morningstar.com as of June 2, 2016.2

  Ditto for insurance (Table 7.3)—even more commission-based than brokers. With lower ratios, they’re less valuable than brokers, but the potential business is huge. Smaller players in Table 7.3 have more total business than many mutual fund families do.

  Table 7.3 Insurance Firm Market Cap versus Sales

  Firm Market Cap (Mil) Sales (Mil) Ratio

  AIG $64,624 $58,327 1.1

  Chubb Ltd. $58,696 $18,987 3.1

  MetLife $49,527 $69,951 0.7

  Prudential Financial $34,683 $57,119 0.6

  Travelers $33,216 $26,800 1.2

  Aflac $28,639 $20,872 1.4

  Allstate $25,273 $35,653 0.7

  Principal Financial $12,765 $11,964 1.1

  Lincoln National $10,819 $13,572 0.8

  Source: Morningstar.com as of June 2, 2016.3

  Note: Huge insurers are older than most brokers and older still than money managers. So the trade-offs are size of opportunity versus value of revenue versus maturity. Think like an OPM founder-CEO. If a law dictated firms could have only up to $1 billion in revenue, no more, then hands down you’d want to be fee-based—the enterprise value would be so much higher. A small success in fee-based goes a long, long way.

  This isn’t to disparage insurance and brokerage—which have created lots of mega-wealth. Some see Warren Buffett as an investor. He’s really an insurance CEO. Berkshire Hathaway’s profits come overwhelmingly from insurance. Buffett’s unusual—most insurance OPMers are in the low billions like Buffett’s ride-along, Charlie Munger. William Berkeley founded an eponymous insurer and is worth $1.3 billion.4 George Joseph sold insurance door-to-door in the early 1960s, noticed auto-insurance firms weren’t screening driver safety right, and started Mercury General to do it better (still kicking at 95, and worth $1.5 billion).5 Patrick Ryan ($2.4 billion) started a firm that became AON, America’s largest re-insurance broker.6 But beyond Buffett, they don’t compare to fee-based wealth—the top 15 are listed in Table 7.4.

  Table 7.4 Wealthiest Fee-Based OPMers

  Name Famous for Net Worth

  George Soros Slew of hedge funds and tanking the British Pound $24.9 billion

  James Simons Hedge funds $16.5 billion

  Ray Dalio Hedge funds $15.9 billion

  Carl Icahn Eponymous firm and tweeting a lot $15.7 billion

  Abigail Johnson Fidelity Investments $13.2 billion

  Steve Cohen Hedge funds and being bad at compliance $13 billion

  David Tepper Appaloosa Management $11.4 billion

  Stephen Schwarzman Blackstone Group $10.3 billion

  John Paulson Hedge funds $8.6 billion

  Ken Griffin Hedge funds $7.5 billion

  Edward Johnson III Fidelity Investments $7.1 billion

  Charles Schwab Eponymous firm $6.6 billion

  John Grayken Lone Star funds $6.5 billion

  Bruce Kovner Hedge funds and a harpsichord $5.3 billion

  Israel Englander Millennium Management $5 billion

  Source: “The Forbes 400,” Forbes (October 6, 2016).

  Beyond Charles Schwab, Sandy Weill ($1.1 billion) also comes from commission-based brokerage.7 But even he evolved out of it. Originally a straight-up brokerage firm CEO, and a dynamite one at that, Weill made his fortune parlaying that into Travelers, an insurer, which later merged with Citicorp to become Citigroup. His big wealth came at Citi on the CEO road (chapter 2), not really from insurance or brokerage.

  As a fee-based OPM founder-CEO, I’m not even successful enough to be among the 15 wealthiest fee-based OPMers. But worth $3.5 billion with my little firm, I’m doing OK and as high as anyone from insurance but Warren Buffett. That’s one attraction of fee-based OPM. You needn’t be as big overall to be more wealthy.

  Still, brokerage is lucrative. James P. Gorman, Morgan Stanley’s CEO, earned $22.1 million in 2015 compensation. Lloyd C. Blankfein of Goldman Sachs got $22.6 million. Neither comes close to some of the mega-paydays highlighted in the first edition, but those were headier times, before the 2008 crisis. It will probably be many, many years before a brokerage exec tops former TD Ameritrade CEO (and current head coach of the Coastal Carolina Chanticleers, an independent football team
) Joe Moglia’s $62.3 million 2007 salary or Lehman Brothers scapegoat Dick Fuld’s $51.7 million. Still, $22-plus million isn’t chump change. Even Bank of America Merrill Lynch’s Brian Moynihan’s $13.8 million is nothing to sneeze at.8 For huge wealth, fee-based is best. But to accumulate $2 million to $50 million, any form of OPM is fine.

  HEDGE YOUR BETS

  Do you like huge risks and returns? Are you a maverick? Fond of big fees? Start a hedge fund. Hedge funds are known as the 2 and 20 model because they charge 2 percent of managed assets annually (i.e., give them $1 million, they take $20,000 yearly)—but also get 20 percent of annual gains! If you’re good, lucky, or both, that adds up quick.

  Say you make one bet—some stock category will beat the market in the next five years—maybe big stocks, energy, or drugs. You bet big on that. You manage $100 million with a 2 and 20 contract. Assume your bet averages 20 percent per year for five years:

  End of year one, your $100 million becomes $120 million. You take 2 percent ($2.4 million) plus 20 percent of the $20 million gain ($4 million)—$6.4 million profit.

  Year two starts and, minus your fee, assets are now $113.6 million. Tack on another 20 percent, take your 2 and 20 fee—$7.27 million profit.

  In year five, your profit is over $10.6 million!

  Over five years, you get nearly $42 million in total fees! That’s just on the assets you started with. Generate high returns and you’ll get more clients with more assets.

  Now, suppose you’re a regular fee-based manager making the same bet—the assets still grow 20 percent a year for five years, but you charge only 1.25 percent a year:

  First year, your $100 million becomes $120 million. You get 1.25 percent—$1.5 million. Not bad, but not $6.4 million.

  Year two starts and, minus your fee, assets are now $118.5 million. Tack on another 20 percent, take your 1.25 percent fee—$1.78 million.

  In year five, your profit is $2.96 million.

  After five years, you’ve made $10.8 million in total fees—good, but far from $42 million. Of course your clients came out ahead because you took less of their money in fees. But a hedge fund manager thinks, “Why not bet big for extra return?” If you’re right, that 20 percent “carried interest” is huge. If you’re wrong, you still collect 2 percent of the assets, annually. Amazingly, if you bet wrong you don’t pay back 20 percent of losses! Of course, if you’re wrong, it’s your clients who suffer. To get big rewards as a hedge fund manager, you must take big risks. Smaller risk means smaller reward.

  Hedge funds aren’t new—they’re just newly popular! Before 1940, swindlers would create two funds. With one, they’d convince half their clients XYZ stock would rise and buy XYZ. In the other fund, they’d convince clients XYZ would fall and sell XYZ short (borrow it, sell it, hope it falls, then buy it back lower, pocketing the spread and repaying the borrowed stock). Neither client group knew about the other. As long as XYZ was volatile, the two funds got 10 percent of that volatility. Clients who lost fired the swindlers and disappeared. Clients who won didn’t understand it was a swindle and would actually give the crooks more money for another bet. This con was put out of business by the combined Investment Company and Investment Advisers Acts of 1940.

  But you can take one side of a big bet on blind luck and hit big or go home. If you’re unlucky, you end up on a different road soon. If you’re lucky, I promise: Few observers will think it’s just luck. You won’t, either. The best hedge funders aren’t just lucky—they’re skilled. But few hedge funds hit big. Most go home. This arena is sprinkled with spectacular successes, yet most hedge funds flame out fast. Few survive two years before all their investors redeem and disappear. I’ve known dozens of folks who started hedge funds—only two survived over the long term. It’s treacherous. Taking monster bets your career rides on is nerve-racking. Jim Cramer quit for just that reason. I’ve seen folks get a run for a few years and then everything blows up on them in no time—ending with nothing.

  Bet on Hedges

  Hedge funds typically operate in specific categories like convertible arbitrage, distressed securities, long/short equity, market neutral, and more. Investors can buy them in multiple categories and diversify (although investors who do this invariably get poor returns because you can’t diversify widely, pay huge fees, and still end up ahead—see Chapter 10 on this relative to being frugal).

  Hedgers also have varied hiring practices. To go this route, just apply everywhere—shotgun style! You can find endless names by doing a Google search—thousands. Most don’t hire. Most are one person, with maybe $10 million to $40 million, operating by him- or herself out of their bedroom. But if you keep looking you’ll find those that hire—they’ll invariably be the bigger ones.

  There’s no security—a fund can blow up fast. I’m not suggesting this for a long-term career except as a founder-CEO or ride-along. But it’s a great place to learn and launch. Work there a few years. Learn what they do. Get the lay of the land. Then you can start your own.

  Hedge funds are lightly regulated, so they’re very easy entry. A law firm like San Francisco’s Shartsis Friese with a hedge fund specialty can get you set up legally and take you through the rules like they’re spitting out popcorn. (Follow this URL for more law firm hedge fund practices: http://bestlawfirms.usnews.com/search.aspx?practice_area_id=33&page=1).

  Then—and you may hate this—it’s all about selling to get clients for your fund. The tactics of running a hedge fund are pretty generic. Pay attention to your law firm’s do-and-don’t rules and then find something you believe the heck out of in terms of doing well looking forward and bet the house on it.

  Often people find one big anchor investor before they start their fund. Say you’ve been a Merrill Lynch broker with a client list totaling $100 million in assets. Among them, you’ve got one big $40 million elephant you’ve served well and put tons of time into. People often decide they can make as much off the elephant in a hedge fund as everything else otherwise. So you quit, start your hedge fund with the one client as an anchor, and then try to build from there.

  This whole process isn’t much more complicated than:

  Betting big.

  Finding clients who will back you in the bets.

  Adhering to the applicable laws . . .

  . . . while you collect 2 plus 20.

  Maybe the most successful recent young hedge fund manager has been Ken Griffin. Now 46, worth $7.5 billion,9 he started Citadel Investment Group in 1990 in a classic hedge fund format. Today he has teams in multiple categories taking big bets on tiny profit potentials, which he leverages heavily for big returns. He’s a phenomenon because most who try what he’s done don’t just fail—they splat.

  Even if you succeed, your future is uncertain. I’ve known Alex Brockmann through his father since he was a boy—one of the nicest guys you could ever meet, and very smart. Alex used to trade Latin American sovereign debt for Ken Griffin and got paid super well for succeeding. He made monster money in 2007—what he did worked—and Griffin happily paid for that. Now he runs a managed futures fund at TradeLink Capital and beat his peers in 2015. But Alex knows he lives and dies by the sword. Alex knows he might not be there at all in 2017 if 2016 fares badly.

  My first example assumed no skill—just blind luck. Ken Griffin obviously has skill. Look back at the list of fee-based OPMers—this is how famous hedge fund managers (Soros, Cohen, Kovner, Simons) made it—by and large taking big risk for giant fees. This requires toughness, as Eddie Lampert knows better than anyone. Lampert’s currently worth only $2.3 billion, but he’s young and could become worth much more. Known for his keen-value eye, he bought Kmart—America’s third-largest discounter—in a 2002 fire sale that most thought was doomed to disaster. But Kmart turned around, initially generating huge returns for Lampert’s ESL fund.10 (Again: One huge risk that worked.) Now he’s trying to fix Sears, which he merged with Kmart in 2005. The jury’s still out, but give him time.

  He almost didn’t get t
he chance. One evening, just after buying Kmart, Lampert left work. Heading to his car he was grabbed by four armed men, blindfolded, bound, and thrown into an SUV. He spent two days bound in a dingy motel bathtub. Lampert believed they would kill him, but remained calm. He noted they were disorganized. First, they claimed they’d been hired to kill him for $5 million.11 No, they were to hold him for $1 million ransom.12 They were armed and terrifying—but also young and scared. Turns out there was no elaborate plan—the four thugs had merely Googled for local wealthy people and found Lampert.13

  Lampert tried negotiating, offering to beat whatever they’d been offered. He claimed they should let him go—that only he could sign for a big ransom check. But his chance came when he overheard them ordering pizza—with Lampert’s credit card! He pointed out the police would be alerted to his credit card being used—hadn’t they thought of that? The only way to avoid prison was to let him go—now—and run. Lampert reminded them he couldn’t ID them—he’d wisely averted his eyes when they removed his blindfold for the one meal they offered him.14 Sunday morning they dropped Lampert off on a highway a few miles from his home. Until they left, he still feared they might kill him. Lampert walked to a Greenwich, Connecticut, police station. They caught the thugs days later.15 Lampert could have panicked or given up. But he remained cool and attentive, thinking creatively of ways to extricate himself. Tough, cool, and collected! Like you must be to succeed in the hedge fund world! Are you that tough?

  PRIVATE EQUITY’S BIG BUCKS

  Akin to hedge funds is private equity—also with a 2 and 20 fee scheme. Private equity funds take over troubled publicly traded firms and fix them to later sell at a profit. These are often called leveraged buyouts. You do the takeover, maybe bring in new management, lop off losing divisions, fund winning ones, and maybe go public again later at higher prices. Done right, it’s super profitable. Part of this is knowing how to borrow well. Another part is the skill to spot troubled firms that can be bought cheaply, because no one sees potential, but can be fixed and profits boosted to fat levels compared to interest costs incurred with the buyout.