What’s Really Wrong With The US Equity Business?

Authored by Nicholas Colas via DataTrekResearch,

Prior to starting DataTrek with Jessica, I spent +30 years in the equity business, first in fund operations, then stock research, hedge funds, and finally writing market strategy for a brokerage firm. That time span represents an entire cycle for “Wall Street” as a business, from starting up a handful of mutual funds that charged 8% loads in 1984 to trading stocks at 0.2% commissions for ETFs that charge 0.04%. It has truly been the proverbial “Long strange trip”.

There are many causes for this downward slide, and each carries a well-worn narrative. A few standouts:

  • Declining asset management fees: Passive investing has seriously dented the popularity of active management, which has admittedly struggled to consistently outperform in the last 20 years of equity market volatility.
  • Lower sell side research margins: Wall Street analysts were hurt by Reg FD and AC, which seriously limited their ability to get a non-public (but once legal) investment edge and deliver that to clients for a premium price.
  • Lower hedge fund profitability: Low barriers to entry allowed too many hedge fund startups, compressing fees for even truly talented managers.
  • Lower equity trading profits: Decimalization, market fragmentation, higher technology costs and long stretches of central bank-driven volatility suppression have killed desk profitability.

Now, equities are an optimist’s game, and there’s no shortage of hopeful narratives that argue we’re at a bottom for many of these trends. The Fed is cutting back on its balance sheet, so volatility will return and lift trading profitability. The next bear market will see investors come back to active management. Asset allocators are more selective now, so the best hedge funds will regain pricing power.

We prefer to consider the decline of the US equity business writ large (both buyside and sellside) through a different lens: long term US equity returns.These, after all, are what pay for the money management, trading, and research services Wall Street has to offer. It is a lot easier to justify higher fees if returns are strong. And essentially impossible to pass along most costs when they are not.

Here are the trailing 20-year compounded average returns for the S&P 500 every 5 years since 1980, underlying data courtesy of NYU Professor Aswath Damodaran:

  • 1980: 8.3% 20-year trailing nominal returns
  • 1985: 8.6%
  • 1990: 11.1%
  • 1995: 14.5%
  • 2000: 15.5%
  • 2005: 11.9%
  • 2010: 9.1%
  • 2015: 8.1%
  • 2017: 7.1%

This data puts trends in the health of the US equity business in a different light than the narratives we outlined earlier. Equity owners – the ones that actually pay for services like money management, research and trading – have scaled their expenses based on their realized returns. For example:

  • The year 1999 at 17.7% 20-year trailing returns was the peak back to 1928, the start of this data series. Ask any old Wall Street professional and they will tell you that was exactly the peak of the US equity business.
  • As of the end of 2017, 20-year trailing returns are just 7.1%, lower even than 1961 – 1980. And the same pros will tell you things are, well, very difficult.

This admittedly non-consensus framework also allows us to take a stab at forecasting the future health of the US equity business. Everyone from Vanguard’s research group to Cliff Asness thinks the Shiller PE (current price divided by 10-year average earnings) is a good heuristic to estimate future returns, so let’s go with that:

  • Current Shiller PE: 32
  • Average real future 10 year returns when the Shiller PE is between 25 and 46 (i.e. like now): 0.5% (see link to a paper with the data below)
  • Assuming 2% inflation, that puts expected future returns at 2.5%

The bottom line here: if this lackluster future return forecast comes to pass, the US equity business will continue to see fee/commission compression for years to come. Asset owners have no choice but to continue to cut their expenses, which are (inconveniently) also the Street’s revenues. That applies equally to the buyside (more passive investing, lower asset management fees) and the sell side (less ability to pay for research and trading).

We will finish on an upbeat note: the current and most likely future environment for the US equity business is ripe for further wide-scale disruption. Asset owners have ripped most of the obvious costs out of the existing system, but if returns are really going to be 2.5% then there will need to be further innovation to incorporate that reality. In that respect, Wall Street is no different from any other American industry. Growth and success will belong to the disruptors rather than incumbents.

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