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Crisis Cliff

Is the financial services industry a Blockbusters waiting to happen?

In 2000 the founder of a brand new company called Netflix, proposed a partnership to the Blockbuster CEO and his team.  The idea was that Netflix would run Blockbuster’s brand online but got laughed out of the room.

We all know what happened next.  Blockbuster went bankrupt in 2010 and Netflix is now a multi-billion dollar company. 

Just as many great financial institutions today, Blockbuster sat firmly at the pinnacle of their industry – seemingly untouchable. With thousands of retail locations, millions of customers, massive marketing budgets and efficient operations, it dominated the competition.  So it’s not surprising that the Blockbuster CEO and his team laughed at Netflix’s proposition to go into partnership with the brand they had worked so hard to build.

Yet Blockbuster’s model had a weakness that wasn’t clear at the time.  It earned an enormous amount of money by charging its customers high fees, which had become an important part of Blockbuster’s revenue model.  These fees were once thought acceptable, but technology was changing and the company’s downfall was based on the company’s profits penalising its clients.

At the same time, Netflix had certain advantages.  By not having retail locations and using modern technology, it lowered costs and could afford to offer its customers far greater value for money.

Netflix proved to be a very disruptive innovation, because Blockbuster would have to alter its business model and damage its profitability in order to compete with the new upstart.  However, despite being a small, niche service at the time, it had the potential to damage Blockbuster’s well-oiled machine.

Many customers loved the new service and told their friends.  Many were reluctant at first, they actually liked being associated with the big brand name (not really knowing how much is was costing them for their brand loyalty) but others jumped right in.  As more of their friends raved about the new service, the laggards tried it too, saw the financial benefits and convinced their friend and family to take a look at it.

Network scientists call this the threshold model of collective behaviour.  For any given idea, there are going to be people with varying levels of resistance.  As those who are more willing begin to adopt the new concept, the more resistant ones become more likely to join in.  Under the right conditions, a viral cascade can ensue.

So what has this to do with the financial services industry … much more then you are thinking right now.

When a company creates a financial product, the decision to go to market and how to market that product is based on how much profit the company will be expected to generate. So for example, if a fund manager decides to create a new global managed fund, they work out how much profit the company wants to earn from the fund and then they go to market and get consumers to put their capital into the fund. Let’s say they are buying 250 stocks globally and charge 1.650% total expense ratio (TER), the company needs to perform and provide an expected market return to retain the investor’s money. Without investor’s money they cannot pay for their offices, salaries, pension, staff etc.

So the bottom line is… as long as investors keep their money invested in the fund, the company gets its anticipated profit. It’s not about the client… it’s about how much profit the company is expected to make.

However, there is a counter argument: what if you start with the client first and not the company profit first.

So in a simplistic manner, let us say an adviser buys their client a ‘wrapper’ to hold the above fund which costs 0.29%, and charges 0.50% per annum to look after their money. The combined TER of the fund is 1.650%.   So the investor’s total industry cost of going to market is 2.44% per annum.

However, what if the advisor informed the investor that if they went elsewhere using the new technology and investment philosophy from these new innovative companies, they could buy the wrapper at 0.29%, plus the advisors fee of 0.50% per annum, and they could buy a mixture of 20,000+ managed and passive stocks for only a 0.30% TER. If they did, the investor’s total costs of going to market could be reduced to 1.09%.

That’s a saving of 1.35% every year!

Let’s say both companies return 5% per annum for 25 years. By investing at the lower cost, because of compounding interest, the investor would generate in the region of 40% more growth than if they invested in the fund paying higher fees. Even if the higher fee fund manager beat the market by 20% per annum for each of these 25 years (very unlikely), the investor would still earn in the region of 10% more growth with the lower fee option.

Is that not why our clients invest…?! Do they not want to maximise their growth? Do they not expect their advisor to be transparent and get them to market in the most financially efficient manner?

One day the industry will have to make a shift as consumers wise up to what’s available in the financial services market place. Like Blockbusters who had a business model that seemed immoveable, there are many in our industry who think the same. It has always worked this way so everyone is happy.

But everyone is not happy … and when the power of threshold model of collective behaviour kicks in, those in the industry that run Blockbuster investment services may have to move fast or get left behind.

Perhaps these new technologies in our industry are already upon us and we should reconsider our proposition… from what is profitable to the industry, to find a way that is profitable for the consumer.

After all nothing happens without the consumer’s money.

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