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The Second Opinion #6: Advisor/Firm Bias
Last month, Mike Macdonald (Second Opinion, Burlington), came across an interesting response from an advisor during a client discussion. The advisor refused to sell an index mutual fund that is sponsored by the firm that they work for. They simply said that despite the fact that the product is sold by their firm, they will not sell it!
What makes a salesperson refuse to sell a product that a client asks for? Perhaps the salesperson is having an ethical dilemma, as they believe the product lacks investment merit despite being offered by their employer? Or, perhaps they are having a financial dilemma? The index mutual fund doesn’t pay them an ongoing commission (called a “trailer fee”); at most, they would get an initial commission or “front end load”, while they would prefer to sell an actively managed fund and get both an initial and on-going commission, and hence, a higher income. Perhaps we are cynics, but on a balance of probabilities (and inspired by our knowledge of industry biases and the benefits of index funds) we would have to say the latter dilemma is likely the correct one.
Unfortunately, it is our knowledge of the industry which leads us to this conclusion. The fact that advisors are paid different commission rates for different products influences their decision on what to recommend—which in turn influences (usually negatively) your financial future. Unfortunately, despite industry assurances that these sorts of things happen only in isolated cases, it does not take a professional long to discover that the industry’s focus is on fee-generating investment products rather than a value-adding investment process. In fact, according to the US-based National Association of Personal Financial Advisors “a financial planner who has a financial stake [such as a commission] in the course of action that he/she recommends to a client faces an inherent conflict of interest and cannot be considered objective and unbiased.”
Being focused more on selling products than providing solid financial advice is not the industry’s only bias. Marketing materials masquerading as educational material and biased research are other examples. The bad part is that these things can hurt your finances. The good part is that knowing about them can help you avoid them. That is why in this edition of The Second Opinion we will focus on Warren’s tip #17 Understand the Biases in the Financial Industry. We would also like to point out an old but still relevant OSC Investor Alert, about being able to tell the difference between marketing material and independent research.
by Warren MacKenzie
Why this is important: It is risky to think the industry is on your side, because to some degree investing is like a competition. If you don’t know the way the other side plays the game, you are at a serious disadvantage.
As Joseph Nocera of Fortune magazine has put it: “A broker with a clientele full of contented customers was — and is — a broker who will soon be looking for a new job. Brokers need trades to make money.” The banks and brokerage firms that form the backbone of the investment industry need profits to survive. They look on you, the investor, as a potential source of profit. Enlightened self-interest on their part ensures that, for the most part, they will treat you fairly, but a company that doesn’t make profits is soon out of business.
One source of profit, of course, is the commissions on transactions generated in your account. In a commission-based account, the brokerage firm and the financial advisor both make more money when the client trades frequently. Obviously, this can create a temptation for your advisor to make more trades than necessary. When this is excessive, it is called “churning,” and fortunately, it happens infrequently. Although some plausible reason — such as recent performance — may be given, the real reason is that the purchase of the new position results in additional commissions being earned.
Some investors’ accounts are charged a management fee instead of commissions. In these cases, the company earns revenues by managing investment assets. In this type of account, the brokerage firm receives a fee that is usually between 0.5% and 1.5% of the assets in the account. Sometimes this fee is a “trailer fee” paid by mutual funds and sometimes it is a management fee paid directly by the client. In this latter type of account, as the account grows, the remuneration grows as well because it is calculated as a percentage of the value of the account.
In theory, this fee-based type of account, sometimes called a WRAP account because a bundle of services are all wrapped into one fee, is better for the client. It removes the incentive for the financial advisor to make unnecessary trades in the account. Since the client does not pay commissions on trades, he or she does not need to be concerned that a recommendation is being made simply to generate revenue for the financial advisor. In a fee account — where the advisor’s fee grows with the growth of the account — the advisor’s incentive is to have a larger account. Both you and your advisor benefit as the account grows.
One risk of a fee-based account, however, is that it may encourage the advisor to take unnecessary risks with your money. A higher return means the portfolio will grow faster and generate a higher amount in fees. If the higher-risk strategy fails, the advisor will lose a small amount of fee income, but you may lose your financial security.
Another industry bias to watch for is promotional material masquerading as information to educate the public. Assume that most of the brochures, newsletters, and advertisements coming out of the financial industry are guilty until proven innocent.
You have likely heard, many times, the following bit of advice: invest in the market and stay for the long term. It is generally good for the industry when investors stay in for the long term, but it is not always good for the investor, and herein lies another industry bias. For example, when investors take their money and buy treasury bills (the lowest-risk investment), few commissions are generated and the brokerage firm’s profits are reduced. However, in a period when the stock markets are overvalued by many traditional indicators, common sense would suggest that very low-risk investments might indeed be the right investment for the average investor.
Brokerage firms and financial advisors are sometimes reluctant to recommend strategies that, while they might be good for the individual, would be disastrous if followed by the industry as a whole. The problem is that an individual may be able to protect himself in the event of a market crash by removing his money from the equity market. But if everyone removed their money, it would cause the very same market crash that they all want to avoid.
If the advisor moved all of his clients to cash because he feared a market crash, he would be out of business because, typically, no fees are generated on cash. When the advisor stops generating fees or commissions, he is literally out of business and his office is given to another advisor who is generating more commissions.
An example of biased advice is the illustration that is often presented in financial seminars showing how an investor’s average return would be reduced if she missed the 20 best days in the market. This example is used to support the argument: Don’t try to time the market. Obviously, if you are out of the market during the best up days, your overall return will be significantly lower. But the other side of this argument is rarely discussed in these seminars. If an investor misses the 20 worst down days in the market, she would avoid losses — in fact, the difference is even greater. If you could choose being out of the market either for the 20 best up days or the 20 worst down days, you would be better off missing the worst down days.
Bottom line: Never forget that in the eyes of the financial industry you are a profit centre. Some of the industry’s “educational advice” is conventional wisdom: for example, start saving at an early age. Yet other often quoted advice, such as to stay in the market for the long term, may be more beneficial to the industry than to the individual investor.
What you can do now: Study impartial books, newsletters, and websites. These are written or sponsored by firms or individuals who are not trying to sell you something. Compare their viewpoints with the information supplied by industry sources.
Second Opinion Vice President John Home recently made his first television appearance as an expert in the financial field. He appeared on the June 24th episode of the show In Tune with Real Estate, hosted Rav Toor. The topic was how real estate fits into your investment portfolio. Unfortunately, due to the short time frame given to us by the show, we were unable to give clients a “heads-up” about the upcoming show. However, John has ordered a copy of his television appearance and we intend on placing some highlights from the show on our website soon. Assuming this is possible, we hope you enjoy it.