Conflicts of interest affecting investors not easy to detect

Most investors would probably agree that getting conflict-free advice from their advisor is not asking too much. The idea that investment or financial advice should put the investor’s interests first seems reasonable enough. In practice, it’s not so simple.

No doubt, many advisors sincerely try to provide objective and conflict-free advice. Wall Street Journal columnist Jason Zweig reported finding hundreds of websites by financial advisers, all aligned with a well-known broker-dealer, claiming to do so. They all touted their “conflict-free” advice or made some similar claim to be free of ethical dilemmas. The idea has powerful appeal, but investors should not rely on the sales pitch. Conflicts of interest are pervasive throughout the financial services industry and they are not always easy to identify.

The most obvious conflicts arise in the sale of commission-based products such as mutual funds with a sales load, annuities, and certain insurance products. A financial professional who is paid by selling commission-based products has a conflict of interest that is typically obvious to the investor. The professional’s interest in selling receiving transaction-based compensation is regulated only by his or her personal integrity and, if subject to regulation by FINRA, by what is currently known as the “suitability rule.”

The suitability rule requires a determination that a particular product is suitable for the investor’s financial situation and objectives. Under current regulations, the recommendation to purchase a particular product needn’t be in the investor’s “best interests,” merely suitable for the investor’s circumstances.

Take the following example. A variable annuity from which an advisor earns a commission might be perfectly “suitable” for an investor looking for tax-deferred growth. However, that product may not be in the investor’s “best interests.” There may comparable products that pay a lower commission or no commission at all and therefore charge lower annual expenses. The advisor is not necessarily obliged to disclose the conflict and inform the investor of the other options.

And even if it’s obvious that the advisor is being paid a commission, the investor may not know the amount of the commission, how it is paid and for how long, and how the commission impacts the ongoing costs to the investor of owning the product. The conflict may be obvious, but the details are not readily apparent.

Another common example involves the use of 529 plans, a very popular tax-preferred education savings account. Many states, such as New York, offer two versions of the plan: one that is only available through financial advisors and for which a commission or load is charged, and another that allows the investors to go direct to the fund company and invest in low cost, no-load funds. If an advisor directs the investor to the commission-based plan without disclosing the lower cost option, have the advisor’s interests taken precedence over the investor’s?

The selection of a mutual fund share class is another common scenario where conflicts arise. Many mutual funds feature a multiple share class structure. The different share classes all own the same underlying investments, but each share class charges the investor different fees and expenses. Some share classes result in the payment of compensation to the advisor, while others don’t. The share class preferred for the advisor’s business model may not be the optimal choice for the investor.

Lest anyone conclude that commission-based accounts are categorically bad and fee-based accounts are categorically good, consider a recent lawsuit involving “wrap accounts.” Wrap accounts are investment accounts in which the portfolio is managed for a fee as a percentage of assets that covers all management fees, commissions and any brokerage fees. They are often promoted as an entrée to superior investment managers. Because there are no separate charges for transaction costs, these accounts may also offer investors the assurance that their account won’t be churned.

A prominent national firm was sued recently in a class-action for moving clients from commission-based accounts with low activity to fee-based managed accounts resulting in higher fees. Regulators refer to this as “reverse churning.” The suit alleges that these investors would have been charged substantially less had they remained in the commission-based accounts. The suit further alleges that shifting these investors into fee-based accounts served the interests of the investment firm at the expense of the investors. The fee-based accounts charged annual fees ranging from 1.35 percent to 1.5 percent of assets under management.

And then we have proprietary products. These are investment products, such as mutual funds and annuities, which are sold by someone affiliated with an investment company or financial firm which issues or sponsors the products. The use of proprietary funds remains common. Banks, credit unions, insurance companies, broker-dealers, and even some advisory firms may offer their own funds because it diversifies their business model and adds an additional revenue stream.

Proprietary products raise a number of issues for investors to consider. For example, proprietary mutual funds may be more expensive than and underperform comparable non-proprietary funds. The offered menu of proprietary funds may be limited from the perspective of desired asset class coverage and diversification. Proprietary products may have restrictions on their transferability, making it difficult for investors to move their accounts in the future. Lastly, advisors who sell proprietary products may receive higher compensation than they would from the sale of comparable non-proprietary products. In the class action mentioned above, the suit also alleges that the firm pushed the use of proprietary funds managed by a subsidiary without disclosing the conflict of interest.

Even fee-only advisors who wish to portray themselves as above the fray cannot escape all conflicts of interest with their clients. Fee-only advisors generally represent themselves as fiduciaries, meaning that they under a legal duty to put the client’s interests ahead of their own. But fee arrangements create at least potential conflicts even for fiduciary advisors.

Consider the very common scenario of an investor retiring with a 401(k) and needing to decide whether to keep the funds in the 401(k) or roll them over to an IRA. Any recommendation by a financial advisor needs to acknowledge the potential conflict of interest. There may be good reasons to leave the plan – lower fees, better investment options – but the advisor stands to lose fees if the client keeps the funds with the retirement plan. The same dilemma is present when an investor solicits advice regarding taking a pension annuity or a lump sum distribution. This is not to say that good advisors won’t give balanced, objective advice, only that the conflict needs to be acknowledged and weighed.

One national firm recently announced, after being prompted by federal regulators, an investigation into “potentially inappropriate recommendations on rollovers for 401(k) plan participants.” Federal regulators have been pushing for a fiduciary rule that would require advisors and brokers to put the investor’s interests first when advising on retirement accounts. Those rules were vacated by a federal appeals court, but the SEC continues to push for more transparency and for the application of an industry wide fiduciary standard.

In the meantime, conflicts of interest permeate the investment business. In the future we will explore the kinds of questions investors should be asking.


This article originally appeared in the May 25th 2018 edition of Rochester Business Journal. Download a PDF copy.

Spotting conflicts in the investment industry

The investment industry is riddled with conflicts of interest. In a complex financial system with a wide array of financial professionals, intermediaries, products and services from which to choose, no one should be surprised that the best interests of the individual investor are not always paramount. Caveat emptor, remember?

Many conflicts of interest are unavoidable and most of them are not going away any time soon. Even the SEC, the principal regulatory body for the investment industry, does not aim for the total eradication of conflicts of interest. What the SEC wants primarily is disclosure – clear and adequate disclosure of the conflicts that have the potential to harm investors. In some cases, the investor’s consent is also required to overcome a conflict.

But even the limited objective of adequate disclosure has been difficult to meet. Not all conflicts are properly disclosed and when they are the disclosures too often are legalistic and lengthy, and thus poorly understood.

It’s important for investors to be able to recognize the conflicts of interest that are inherent in our financial system, because only then can they make intelligent decisions to avoid them or mitigate their impact. What follows is an introduction to spotting conflicts of interest relevant to investors.

Conflicts of interest are arrangements that carry the risk that our money may not be handled in our best interests. Individual investors collectively own most of the U.S. stock market; in that sense, it really is “our money.” If we aggregate what individual investors own directly in shares and indirectly through mutual funds and retirement plans, individual investors collectively own about 60 percent of the market.

As investors, we take a portion of our accumulated capital and set it aside for future consumption by investing it. We hope to earn a sufficient return over time to have enough money to meet future spending needs such as retirement. But are we getting a fair deal? At the macro level, there are reasons to believe that we are not.

Cost savings not passed along to investors. A 2012 study by a professor from the New York University Stern School of Business suggests that whatever cost savings have been achieved in the finance industry are not being passed on to end investors. Going back to 1886, the authors attempted to measure the unit cost of financial services or, to put it another way, the investor’s cost to engage with the financial system through one or more financial intermediaries.

The study concluded that annual costs to investors have stayed relatively constant at between 1.5 percent and 2 percent and that there is no discernible trend toward lower overall costs for end investors. If true, it suggests that any gains in efficiency and productivity, especially from the improvements in information technology over the past several decades, have been pocketed by the industry and have not been passed along to investors. As evidence, the study notes, “the income of the financial sector accounted for just 4 percent of gross domestic product in 1950, but by 2010 that had doubled to 8 percent.”

The proliferation of financial intermediaries. Why have investors generally not benefited from gains in efficiency? One explanation might be the proliferation of “financial intermediaries” that come between our money and us. This issue was examined in a recent book, What They Do With Your Money: How the Financial System Fails Us and How to Fix It. Although the authors praise the contributions of our financial system in driving economic growth and prosperity, calling it “one of the great achievements of modern times,” they spend most of their time examining some deeply rooted flaws and how to fix them.

To illustrate the role of financial intermediaries, the simple act of participating in a 401(k) might involve five or more intermediaries: a plan advisor, a record keeper, possibly a separate clearing firm to handle securities transactions, a third-party administrator, and multiple mutual fund companies. Each intermediary provides important services but they all have to be paid. Some or all of these services are paid for out of the investors’ funds, but investors have little to no control over how much those services cost. The intermediaries are either invisible to the investor or poorly understood by them.

Any investor who works with a financial professional, perhaps a broker or a registered investment adviser, is adding a layer and more cost. If the professional outsources the actual investment management to a turnkey asset management provider (TAMP), an increasingly common practice, there is an additional layer and cost.

The authors of What They Do With Your Money argue that, at its worst, the financial industry treats investors’ capital as a “virtual ATM” to draw against. That may be a bit too cynical. A more balanced assessment may be that, as the authors put it, “The chain of financial intermediaries has grown so lengthy that there is no longer a line of sight between us, the providers of capital, and all of the agents.” The resulting opacity makes it difficult for investors to determine whether the value received is commensurate with the cost.

Serving two masters. The basic dilemma presented by the investment industry as a whole and by the mutual fund industry in particular is this: the business model serves stakeholders with conflicting interests. The sponsors of the largest mutual fund companies are owned by publicly traded banks and financial conglomerates. These companies owe a duty to their shareholders to maximize profits. However, the mutual funds they operate owe a duty to their investors to maximize their net returns. The interests of these two sets of shareholders are in direct conflict.

The incentive of publicly traded companies to maximize their own profits serves the legitimate objective of benefiting their shareholders. Investment companies are incentivized to maximize profits, to charge what the market will bear, to take on greater investment risk, and to launch new and innovative products to draw more assets.

Those actions may be at odds, however, with the interests of mutual fund investors in maximizing their net investment returns. Investors are not necessarily benefited by the additional risks taken by fund managers or by innovative investment strategies based on back-tested theories. On average, investors are better served by investments with lower investment fees and expenses.

To the extent the interests of investment companies conflict with the interests of investors, there is reason to believe that the interests of investors will come up short. In future columns we will look at some specific conflicts of interest that investors confront, especially those relating to product selection and fee arrangements.


This article originally appeared in the April 20th, 2018 edition of Rochester Business Journal. Download a PDF copy.

Complex products are stacked against the investor

In the world of investment products, investors should keep in mind one simple rule: complexity favors the house. The house in this context is the investment company selling the product. Investor, complexity is not your friend.

A recent study looked at the use of complicated investment strategies in mutual funds. The authors examined this question: “Does complex instrument use by mutual funds benefit or harm the fund shareholders?”

Over the past fifteen years the number of funds using hedge fund techniques has increased over a hundredfold. The study looked at three techniques in particular: leverage, short sales and options. Lest you dismiss those techniques as irrelevant to your investment portfolio, consider that more than 40 percent of US stock funds reported using at least one of these techniques and over 60 percent of such funds disclose that they are authorized to use all three techniques.

“Leverage” refers to the ability of a mutual fund to borrow money to fund portfolio purchases. A mutual fund can leverage up to a third of its portfolio value. A “short sale” is the sale of a stock that the fund does not own. A fund might borrow stock from another owner and then sell it on the belief that the stock price will drop. The fund hopes to reacquire the stock at the lower price, return it to its owner, and pocket the profit. If, however, the price of the shorted stock goes up, the fund takes a loss. “Options” are financial contracts that place a bet on stock prices moving up or down over a specified time period.

The findings of the 2017 study were not favorable for the investment firms that sell these funds. The authors found that funds that use these techniques tend to cost more, produce lower returns, and experience higher risk. For investors, those are three key metrics moving in the wrong direction.

Several other findings are worth noting. First, funds tend to start using these more complicated techniques after a period of underperformance and fund outflow, suggesting that they are taking on more risk to “catch-up.” Second, compared with funds that don’t use such techniques, funds that do tend to have worse negative outcomes and more of them. Restated, if you were to plot the outcomes of all the funds using these hedging techniques, you would find the graph to be skewed to the left where the negative outcomes are plotted.

Third, and perhaps most interesting, was this finding: “The only setting where the use of complex instruments is not associated with negative shareholder outcomes is when funds use complex instruments in the presence of high levels of institutional ownership.” In plain English, where fund managers have their own stake in the fund – this is known as “eating their own cooking” – they tend to produce better outcomes. They are, perhaps, more conservative in their use of these strategies when their own money is at stake.

The study’s findings do not mean that hedging strategies are categorically bad or wrong. Used appropriately, they can help to reduce risk. It does appear, though, that their merits in theory and their benefits in practice are not necessarily the same.

The study’s findings suggest some basic principles that investors would do well to remember.

  1. Betting against the market is risky. We know from other studies that betting against the market is, on average, a losing strategy. The investment strategies covered by the 2017 study amount to making bets against the market. Carefully consider whether that is a strategy you want or need to purse, and then consider the fund manager’s track record making such bets.
  2. Other people’s money is different. The way some funds handle “other people’s money” is not necessarily the same way they’d handle their own money, fiduciary duty or not. Do you want to invest with a manager who doesn’t eat his or her own cooking?
  3. Know what you own. A fund’s ability and its proclivity to use more complicated investment strategies may not be obvious but it will be disclosed in several places: the prospectus, the statement of additional information, and the annual report. The information is hidden in plain view.
  4. More complexity means higher costs. Unless proven otherwise, assume that complexity is your enemy as an investor. The more complicated an investment product is, the more it tends to cost, and the higher the cost the greater the likelihood that investment performance will disappoint.

Needless complexity should raise your suspicions as an investor because it stacks the odds against you.


This article appeared in the March 15th, 2018 issue of The Daily Record. Download a PDF copy.