Two Painful but Inescapable Truths
The Financial Burdens of Institutional Trustees and the American Public
“You will perceive Sir, I have neither flattered the state nor encouraged high expectations. I thought it my duty to exhibit things as they are not as they ought to be.”1
—ALEXANDER HAMILTON (August 12, 1782)
Nearly one year after British forces surrendered to the Continental Army at Yorktown, the American colonies were in disarray. In the summer of 1782, Robert Morris, a key financier of the Revolutionary War, dispatched colonial leaders to report on economic conditions throughout the colonies. Many drafted reports that downplayed the widespread desperation because they believed reality was too difficult for Morris to bear. A notable exception was the nation’s future Treasury secretary, Alexander Hamilton. Unlike his peers, he believed that the progress of the nation could only be achieved if it was grounded on an accurate assessment of the present. Hamilton’s report described the dire economic conditions in New York exactly as he saw them.
This newsletter describes two unpleasant financial truths. The first must be addressed by trustees of institutional investment plans, and the second must be addressed by all Americans.
Truth #1: The Burden of Complexity & Fees in Institutional Investment Plans
“The customer may not always be right, but he has rights. And upon our recognition of his rights and our desire to satisfy them rests our chance to succeed.”2
—CHARLES E. MERRILL, founder of Merrill Lynch
On July 24th at 10:00 am PST, I will be hosting a free webinar, entitled “It Pays to be Different: The Rationale for an Indexed OCIO.” The presentation explains why most institutional investment plan trustees now find themselves responsible for portfolios that are overburdened with complexity, active management, and alternative investments. It will also explain why this behavior persists despite a mountain of evidence demonstrating that it is highly unlikely to add value.
Trustees, investment staff, journalists, consultants, and individuals who attend this webinar may wince when they see many of the facts. I confess that when I was a former investment consultant, I initially had the same reaction. I feared that clients would fire me when I migrated them to low-cost index funds. Fortunately, I quickly discovered that their reaction was precisely the opposite. By freeing clients from the burden of non-value-added investment practices, they placed a higher value on my advice, which meant that we all benefited.
It may seem strange to include a quote from the founder of Merrill Lynch to promote a webinar dedicated to the benefits of low-cost index funds, but the transformation of Merrill Lynch in the mid-1940s had much in common with the transformation that is now necessary for institutional investment plans. Therefore, to place this quote into clearer context, I have included an excerpt from my book, Investing in U.S. Financial History: Understanding the Past to Forecast the Future at the end of this newsletter.
Truth #2: The Unsustainable Growth of the U.S. Public Debt and Entitlement Spending
My April 26, 2024 newsletter was the first in a series of three newsletters describing the greatest financial challenges for the United States in the coming years. The first challenge was relatively short-term, as it described the challenge of post-COVID inflation. The second newsletter addressed the costs of wars that can escalate unnecessarily. The final newsletter will address the unsustainable growth of the public debt and its root cause, which is the massive growth of spending on entitlements.
In a recent conversation with a friend, I was asked what was the most surprising thing that I learned from researching the financial history of the United States. The answer was the shift in perception on the use of the public debt and the affordability of entitlement spending. Prior to World War II, the public debt was primarily used to address “times of public danger” and then repaid once the danger subsided. This precedent was first articulated by Alexander Hamilton in his January 9, 1790 speech, entitled Report Relative to the Provision of the Public Credit. For more than 150 years, the United States adhered to Hamilton’s principle. Then, in the aftermath of World War II, Americans became emboldened by their exceptional wealth, formidable competitive advantages relative to a world in ruins, and privilege of holding the world’s dominant reserve currency. This set the stage for the steady expansion of entitlement spending which continues to this day.3
The problem that the United States must now confront is that its post-World War II wealth and competitive advantages relative to the rest of the world were historical anomalies. That is not a disparagement of the nation’s current competitiveness; it just means that the gap relative to the rest of the world has narrowed over time. This being the case, entitlement spending that once was deemed affordable is clearly not. This is not an easy problem to solve, but accepting the fact that the problem is very real is the first step to solving it. More to come on this issue.
Pre-Reading for Trustees
For subscribers who wish to attend the free webinar on July 24th, I have created a web page that provides some optional pre-reading. Included are several articles I have written over the past few years. They cover issues such as (1) the history of the prudent investor rule, (2) the history of active management, and (3) and the conflict of interest at the heart of the investment consulting model. I hope the webinar and these resources help inform trustees’ decisions.
Book Excerpt: The Long-Term Rewards of Honesty versus the Destructive Fear of Obsolescence4
“The customer may not always be right, but he has rights. And upon our recognition of his rights and our desire to satisfy them rests our chance to succeed.”5
—CHARLES E. MERRILL, founder of Merrill Lynch
When faced with moral dilemmas, characters in old cartoons consulted with an imaginary devil on one shoulder and an angel on the other. The devil encouraged acts that were wrong but self-serving, while the angel encouraged them to do what was right but seemed self-destructive. In the long term, the angel’s advice always proved to be both right and rewarding, while the devil’s advice provided short-term relief at the expense of long-term self-destruction.
Investment professionals are constantly presented with this dilemma. Serving clients honestly—which is in every investment professional’s long-term interest—often requires accepting truths that seem self-defeating in the moment. This is because the truth forces them to recognize their limitations, alter their behavior, and adapt to a new reality. Those who respond well to these existential dilemmas place themselves in an unexpectedly powerful position because an investment professional’s greatest asset has always been and always will be their willingness to communicate the truth. Over many years, adherence to this principle ebbs and flows. During periods in which collective fear of obsolescence dominates, the few who buck the trend and communicate honestly with their clients are rewarded beyond their wildest expectations.
Merrill Lynch’s commitment to honesty, integrity, and transparency rehabilitated the reputation of Wall Street in the decades following World War II. The firm, its employees, its customers, and Americans in general benefitted from their bold decision. Sadly, their commitment eventually weakened, as it almost always does as companies age. After the firm’s adherence to its core values eroded in the early 2000s under the leadership of Stanley O’Neal, Merrill Lynch nearly disappeared forever beneath the wreckage of the Global Financial Crisis.
Merrill Lynch survived as a subsidiary of Bank of America, but its reputation is not what it was in the 1950s and 1960s. History demonstrates that it is never too late to regain the trust of Americans, but doing so requires them to open-mindedly explore what customers need and humbly accept the limits of what they can provide. It is unclear if Merrill Lynch will resurrect the principles of Charles E. Merrill and Winthrop Smith, but if they do, their employees and customers will once again enjoy benefits that they never anticipated were possible.
Disclaimer: This is a personal newsletter. Any views or opinions expressed herein belong solely to the author and do not represent those of any people or organizations that the writer may or may not be associated with in a professional capacity, unless specifically stated. This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are no guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
Alexander Hamilton, Letter to Robert Morris, 13 August 1782. https://founders.archives.gov/documents/Hamilton/01-03-02-0057-0001
Winthrop H. Smith Jr. Catching Lightning in a Bottle: How Merrill Lynch Revolutionized the Financial World. (New York: John C. Wiley and Sons, 2014).
Alexander Hamilton, Report on a Plan for the Further Support of Public Credit, January 16, 1795.
Mark Higgins, Investing in U.S. Financial History: Understanding the Past to Forecast the Future, (Austin: Greenleaf Book Group, forthcoming February 2024).
Smith Jr. Catching Lightning in a Bottle: How Merrill Lynch Revolutionized the Financial World.
Just ordered your book, Mark. Love investing (obviously ... lol). Love history. Read the reviews on AMZN. Looking forward to reading it ... Bill Patalon III, Stock Picker's Corner.