Conflicts of Interest and Misrepresentation: Domination of the Financial Advisory Business by Fund Managers
In the second of three articles on the savings and investment industry, economist and investment portfolio manager Dr Gareth Morgan examines why investment product providers have been able to get away with charging fees so high that they render the returns to mum and dad investors woefully lower than returns they can enjoy from other investment options.
If a door-to-door brush salesman told you that one brush in his quiver was better than another, would you be convinced he was acting in your interest? Would that advice be worth anything? He gets paid no matter which brush you buy – just buy a brush won’t you?
Yet this is precisely the practice that permeates the so-called financial” advisory” business in New Zealand. At least with a brush salesman the disguise is wafer thin – only the really gullible believe he has any purpose apart from selling you a brush. But when somebody charges you as your investment adviser, validated by credentials from a national professional body of advisers, you might be forgiven for thinking that he is what he claims he is.
The standards required of financial advisers are so low that a person can tell you he is here to advise you (and in so doing infer that like your accountant or your lawyer, your welfare is his professional concern) when there is nothing further from the truth. His sole purpose is to sell the products of fund managers, from whom he receives at least part of his remuneration.
White-shoe commission abound in the financial advisory business. The integrity of the investment advice business has been so compromised by insurance companies and fund managers that most advisers double-dip – receiving both commissions from the product providers as well as charging fees to their clients – all the while misleading investors that they are their “advisers”. The conflict of interest is total.
The investment advisory industry in New Zealand is so infected with self-interest that the investors’ interests rank last in a very long chain, perpetuating an arrangement wherein systematically mum and dad investors are fleeced of most of the returns their investments make. There is nothing wrong with self-interest of course but when its pursuit comes at a cost of gouging investors’ returns and the market is insufficiently competitive to eradicate the practice, there is at least a prima facie case of market failure.
Herein lies the basis of the market dysfunction that allows inequity between seller and investor to persist. Fundamental to the conflict of interest that self-named “advisers” have, is their payment by product providers. The rewards from the duplicity can be handsome. Successfully misrepresenting themselves to investors as their advisers establishes an element of trust, undeserved and unearned though that may be. Because the client understands one thing by the label “adviser” that is quite different to how the industry has usurped and re-defined the term within its own lexicon, a myth is perpetuated and profits are made from that misrepresentation.
Our detailed examination of the charging regimes for investment products and providers has illustrated just how far down the chain the investor is. The extent of the skimming measures the degree of market failure. One way to demonstrate how divorced investors become from their rightful returns is to ask the question, – “how much does one have to earn from these things, just to avoid losing one’s wealth?”
In this experiment we’re simply trying to find out the gross return a product must give to deliver a zero return – paltry for sure, but beats losing money! Starting with the ideal option of no fees and no tax on capital gains, if inflation is 2%, then to avoid going backwards obviously you have to earn 2% after taxes. Investing in shares involves paying taxes on dividends so the actual return required is 2.2% under our assumption for all shares that 30% of the return comes by way of taxable dividend and 70% through capital growth.
But once we move beyond this ideal, the required return gets significantly higher as the table (for an investment of $100,000) summarises. The reality is that an investment via an intermediary has to provide around 6% just for the investor to avoid losing wealth.
What is the chance of a fund making a 6% nominal return? US data suggests the stockmarket will manage that 65% of the time, the average fund 20% of the time, or 1 year in 5.
There’s no doubt these products and supporting systems are so bad that only misinformed investors would persist throwing good money after bad. It is indeed a triumph of marketing over transparency that they continue to do so, like lemmings over a cliff.
That the institutional fund managers are the primary party misleading investors speaks volumes of how irresponsible their position of care is for the public’s savings. They are quite happy of course for field lackeys – which is what any commission-rewarded product salesman is – to perpetuate the myth because it underscores the funds inflow which is the institution’s lifeblood. Increasing funds under management rather than maximising the performance of those funds in the hands of the investors, is the key to the bottom line success of fund managers. That is one reason financial services companies continually lobby politicians to address the “dearth” of savings. Success at the lobbying hearings can markedly increase the funds under their “care”. The Cullen Fund and reconstituted Government Superannuation schemes are testimony to that. Investment performance is very much a second order priority for these firms.
Indeed the cartel between the fund managers, financial services companies and “advisers” provides each party with a security of income from the saving public. Financial services companies and brokers provide the platforms for undercapitalised one-man-band advisers to be in the field, working their powers of persuasion to capture household savings. There are few if any “advisers” in New Zealand who are adequately qualified in investment markets, are equipped in more than an amateur fashion to understand the nexus of social, economic and financial forces that shape investor returns. By far the majority are very familiar with the product characteristics of their sponsor’s products, what commissions they deliver and how to sell.
Now there is nothing wrong with salesmen – whether they be salaried or commissioned. But there is something dramatically wrong when that person perpetuates a myth – that the self-interest of the salesman is served best by the investor getting good returns. On the contrary, the interest of the salesman is best served by the readiness with which you buy his product, and by volume he sells.
That the regulatory environment has permitted this misrepresentation by “advisers” and their sugar daddy product provider/employers, has much to answer for in the abysmal performance track record of New Zealanders’ savings. And it follows the despair investors suffer prior to eventually turning their back on managed funds as suitable vehicles in which to store their savings. A preference for residential property has been one consequence. Too often investing in managed funds has done no more than line the pockets of the finance houses.
For markets to function efficiently participants must have full information. The conspiracy between investment advisers and product and platform providers goes out of its way to ensure that investors do not get all the information they need. In fact the protection put in place by suppliers range from blatant lies to deliberate lack of disclosure. Even where there is disclosure it is often in a form that is incomprehensible to customers – designed to baffle more than to assist. In our survey we found it incredibly difficult to get data from advisers on past performance – indeed a few simply said it was not available.
An obvious question is what can be done to clean up what is a sleazy business manned by apparent upright citizens in suits but with a moral code insufficient for investors to be able to trust. In the US the behaviour of the financial services industry has been so corrupt that jail sentences and fines have become almost passé. A number of protective regulatory measures are being implemented.
- (a) separation of fund governance from the affairs of its manager. Virtually always the Promoter of a fund to the public becomes the manager or administrator of the fund. Through this route they ensure the fund serves their objectives primarily, rather than those of investors. Fees and expenses – many of them undisclosed – end up lining the pockets of the manager. In the US the chairmanship of any fund promoted to the public must now be independent of the manager
- (b) separating advisors from fund managers. In New Zealand we have made some small progress with the 1997 Advertising Board ruling that it’s unlawful for an adviser to use the word “independent” while selling product that he has an interest in as promoter, manager or administrator. Yet it is still possible for an adviser to call themselves independent while receiving sales bonuses for selling more and more of a provider’s product
- (c) disclosure is increasingly seen as a weak-wristed remedy of the information asymmetry. In order to take advantage of full disclosure the investor has to be able to understand the information provided. Obfuscation is a skill set perfected by insurance companies and in the UK, Australia and the US disclosure is generally regarded as necessary but insufficient to address the information disadvantage.
- (d) Trustees actually stepping up t their supposed duties. There is a readily available cop-out for trustees from their duty of care. That is in taking professional advice and using that in their defence. The screws are being tightened on this wimp-fested escape with the intended result that trustees either shoulder their responsibility or resign.
In summary, retail investors receive paltry returns because they are not well informed on how much gouging is taking place, the minimal onus upon providers to reveal all fees and expenses in plain English, and the corruption of the advisory business by the commissions providers pay them – some declared, many hidden.
The third and final column in this series considers the hurdles facing government in cleaning up the investment industry and how far it is from providing a cogent environment for New Zealanders to protect their hard-earned wealth.
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