Sunday thoughts on Conflicts of Interest

I have a friend by Lake Geneva with experience, understanding and skill in the business of wealth management; he has spent decades successfully looking after the wealth and the interests of many Families across the world, with great sense of duty and unparalleled integrity by any standard, and his success is not measured by his balance sheet or by the wealth he accumulated.

One day last spring, during one of those moments of intellectually exciting and honest exchanges that occasionally occur in the life of a financial services professional, he told me; Fabrizio I spent a lot of time trying to explain to Clients the conflicts of interests that litter our world, and almost always without success.

This phrase struck me deeply, and I struggled to understand where the challenge lay in explaining something that is both so obvious and so damaging, that even the most trusting and naïve of Clients should spot without too much difficulty.

The key to the riddle came when I forced myself into remembering what I believed about financial Advisors, banks, bankers, stock markets, rating agencies and al the rest, 20 or so years back, before I started my unorthodox journey within the financial services industry; what a discovery!

I remembered looking with intrigue at fund marketing books, economic reports, research and offering documents supplied by some polite and well groomed relationship manager. I loved those charts full of coloured lines all pointing up, the smart offices, the opinionated speakers that we were introduced to, all using very complex and resounding terminology. I was full of admiration for their skill and their mastery over finance.

So indeed I believed that all the people that worked in banks knew something about the financial markets, about investing, about economics, about credit, about wealth preservation, about compounding, about risk, and that they could, and that they would advise me. I truly believed that you took your money to the bank to keep it safe, in the hands of smart people that had your interests at heart.

Where could one find a conflict of interest within this belief set? What a fool I was! My eyes blinded my ears deaf, defenceless and unaware prey to a well-seasoned pack of poachers.

Don’t get me wrong, plenty of smart people in the wealth management, private banking and banking business, but your savings, your cash are their balance sheet, and that is what they live and die for, nothing matters more than their Assets Under Management, and their Return On Assets. Which translated in layman’s terms means how much of others people`s money do we hold, and how much of it can we make ours this year.

Over a decade later, still young at heart, still passionate about investing, about detailed and thorough research, still intrigued about speculation, about market behaviour, about understanding and taming risk, and after the luck of having met with, and understood the best and the worst of my industry, I want to try and talk to my readers about the conflict of interests between Advisors and their clients.

The common denominator of most forms of conflict of interests in this business lies in someone providing paid or unpaid advice aimed at generating a benefit to the party giving the advice, rather than to the party receiving it in good faith.

A more formal definition reads; “A conflict of interest is a set of circumstances that creates a risk that professional judgment or actions regarding a primary interest will be unduly influenced by a secondary interest”.

There are endless interpretations on what Advisors obligations are, or should be, in regards to decision making on behalf of clients. The term “Fiduciary duty” has found its way into regulatory and contractual language to try and describe them.

From this writer’s perspective the duty of an Advisor, particularly if remunerated, is Loyalty, with the duty of loyalty described as “the willing and practical and thorough-going devotion of a person to a cause.” In this case the Client’s cause. The requirement to be loyal is thus a constraint on a party’s discretion to pursue self-interest, prohibiting the power the person has to be used for other goals then it was intended for; the furthering of the interests of the Client.

The best way to detect some elementary, and now “industry standard” forms of conflict is to discover how people and organizations are paid or generate revenues for the services that they offer.  If you understand how your banker or Advisor is paid, you will have a key to understanding the true motives behind most of his advice.

This standard conflict materialises when Advisors are also acting as distributors of services or products in return of a fee, be it either in a concealed or disclosed manner.

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Almost every fund management house and every bank distributes products to their clients representing them as best in breed, and simultaneously receiving a retrocession, commission, profit share, soft dollars etc. from the issuer of the product in return of their placement service. Duty of Loyalty anyone?

Regulators across the globe have started forcing disclosure of this practice, but they are way behind the curve, in the financial industry laws are made to be circumnavigated; every week you will read about some institution, paying a large sum to settle the allegations of a regulator without admitting any wrongdoing. All major financial institutions settle dozens of these occurrences every year. This means that they likely broke the law, that they likely failed in honouring their fiduciary duties and that they profited handsomely in doing so. If discovered they pay a fine and business as usual.

While this first kind of economic conflict can be easily spotted, by asking for full disclosures, there is a more subtle one, a much worst felon, a behavioural pattern that without creating a visible economic benefit to your Advisor, still impacts his actions, swaying them away from your goals, and turning your portfolios into something that fulfils his goals rather than yours.

This form of “conflict in thought” is difficult to measure and to demonstrate. It is a behaviour that prevents the correct actions from being implemented with your wealth, eventually denying your capital of its growth, while preserving the profitability of the account for the Advisor.

The conduct of many Advisors will be governed with the ex-ante purpose of his proposed choice, things like; we have to preserve your wealth, we cannot do “exotic” investments that are too risky, your portfolio should be liquid, let’s buy something conservative, bonds are safe, we do not speculate, etc. etc…  If we then go and look at the ex-post affects that the advice, or choice might actually turn out to generate, we will find a great variability in the outcomes in your portfolio compared to the stated goals, but almost certainly very little variability on the economic outcome for the Advisor: his fees get paid independently of the outcome.

But while the effects of advice received and implemented are objectively verifiable, the Advisor’s intentions usually are not. In most instances, the intentions of the Advisor cannot be deduced from the results of the advice or actions.

Let us be practical with some examples; an investment Advisor relies on you as a client to fulfil his economic objectives, the fees he earns from you are his livelihood, and because of this dependence he will most likely avoid making investment decisions that could be regarded as being outside of common wisdom, he fears that they could turn into an Achilles heel for him, not for you.

Instead if he conforms and invests like everyone else, irrespective of whether you will achieve your goals, his results will not be very different from the ones of his peers, he will be able to blame the markets, the economy, the lack of regulation, too much regulation, politics, religion, the war or whatever other systemic and external cause that history provides in that moment for your circumstances, and thanks to this camouflage he will most likely retain your business, and with it his revenues.

One could argue that a certain outcome from advice can be the natural result of a choice of action within the acceptable range available for the interest to be served. However that same outcome might very well be the result of a choice of another action within the same range, but which was preferred above other actions because it also served another conflicting interest. And it is very hard if not impossible to distinguish between these two actions, but while both actions are within the margin of discretion, only one of them is a legitimate choice in light of the duty of loyalty.

As a result, the enforcement of a duty of loyalty is extremely difficult. The economic incentive available to the person with the duty for disregarding it, coupled to the low risk of being caught, means that there is a much stronger than standard incentive to breach a duty of loyalty, thus explaining why this phenomenon is so wide spread.

Good examples of Advisors that are “conflicted in thought” are trustees and other institutional Advisors that hide behind “wealth preservation” or avoidance of risks to justify their inactivity, or their conformity; their only true interest being deferring any professional liability, preserving their status quo and/or their earnings and avoiding any risks that are not beneficial to them. What this really means is that they are shifting the goal of the investment mandate received from their Clients, and invisibly aligning the mandate to their own personal goals; from growing and transmitting wealth to the future generations of their client, to securing a cash flow for their business.

Anyone that uses benchmarks of any sort normally lies within this group: believe me, no one can go shopping or buy a house with the out-performance above a benchmark that is under water. Of course measuring performance is a complicated topic; there are very effective ways to do so objectively, not benchmarking.

So in practice how do we deal with these conflicts? It’s impossible to do so ex-post, but it is quite easy to do so while drafting economic agreements with your Advisor. You should contractually agree to be rebated all cash flows that he receives as a consequence of investments done on your behalf, you should pay him a minimal fixed fee and you should share with him part of any gains he generates. His money should be invested alongside his clients’ money; he should be on the firing line with you. You should study the organization carefully, remember that ex bankers are almost all very social sales people, and very few are investment professionals; relationship managers and wealth managers are recruited for their sales, social and human skills, for their connections and address books and not for their financial savvy.

A good Advisory firm will have at least 50% of its staff composed of investment professionals, risk takers, quants, economists and analysts, the more senior the better; markets are a survivors game. Today’s markets are complex, infrastructure is important and teams should be substantial in numbers, 15 or more. A good firm will have dedicated risk, legal and compliance functions, a very well organized middle and back office, efficient systems and high grade IT. Only about 10% of staff will be client facing and sales oriented people. Beware of people with big egos. Do not stop at the organization chart they give you, enquire about the background, previous jobs, education and passions of the key decision makers, meet them all and verify, discover about the rate of employee turnover, ask difficult questions, don’t believe anything you are told, always give all sell side information a substantial haircut!

As already stated, and most importantly ask how people are paid; you have a right to know it! If people are paid for bringing in new money, that is what they will focus on, if they are paid to generate investment returns, that is going to be their focus. Ask for their accounts, check if they are financially solid, and what reserves they have. Go on the regulators website and check their regulatory history. Avoid firms with too few clients and wholesalers with too many. Have your lawyer or a third party review the investment mandate agreements before signing them. If a firm refuses to disclose these details to you, just walk away, there are many other good firms out there that will be willing to serve you in a transparent and aligned manner.

Once you shortlist a couple of firms, you should focus on their proposals, have their people educate you, take a real interest in what you are being offered, do not be afraid of asking questions, it does not matter if you do not know, ask, and ask again until you understood, and if the story does not convince you start again until you get comfortable. If it’s too complex it’s probably not good anyway.

Beware of shortcuts, people that simplify, that avoid detail, that are not granular in their analysis that try to convince you of something rather than listening to what you want, these are normally sales people trying to fudge their way in an investment role. Investing is about research, about hard work, about attention to detail, about network and contrarian thinking. Avoid proposals made of “shortcut” products; proxies like ETF`s and structured products, these are hugely inefficient, expensive and contain a variety of risks that are different from the ones you are seeking, including liquidity and counterparties risks. Structured products are darlings of the retrocession game; they pay handsomely Advisors for “pushing” them on to clients!

Pay attention to the Total Expense Ratio, of these proposed portfolios, there are several layers of fees; Your bank will charge you custody and transaction fees, a fund you acquire will also pay a custodian, and a broker to execute it`s transactions, it will pay administrators, managers and directors, so you should understand all these layers of fees and get your Advisor to express these numbers in detail. Once you add up all costs, including the Advisor, you will see that the TER can fluctuate between 1.5% and reach as much as 4% per annum. Let me attempt to explain what this means for a 10 million portfolio over two generations considering a 50 year period and a yearly average return of 6% over the cycle; As you can see, from the chart below a 6% return with 0 fees and regular compounding will become almost 180 million over the 50 years.

Growth of 10 million at 6% p.a. over 50 years with different TER’s

Growth of 10 million at 6% p.a. over 50 years with different TER’s

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If you now look at the table above, you will see the striking difference in ending capital with different levels of fees. This is to say that when you negotiate fees, you should think long term, you should be aware of the negative effect on the ability of your capital to compound, generated by fees.

The assumption above is a theoretical representation and depending on the credit and economic cycle the distribution of returns could vary substantially, in either direction, but it is a good enough approximation for our purpose of explaining what fees really do to your wealth.

Let us now simulate the impact on your wealth of the Advisor that is “conflicted in thought” and let us assume that his passive attitude causes a rate of return that is 3% per annum smaller than what could be achieved by a more “risk seeking” Advisor, that we hold steady at 6%.

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The hypothetical difference in annualized returns, over the same two generation timeframe, equates to over a 100 million (10 times your initial capital) on a 0.5% fee structure, up to a “low” of 58 million and change with the highest TER we examine in this case.

Did you feel how unusual the expression risk seeking sounds? How many times have you come across someone that told you he was going to be risk seeking with your assets? What do you think you get paid for in the markets if not for taking risk? For what other reason should you earn a premium? Beware of people that instil fear and too much conservatism to your investment mind-set, it is often a conflicted attitude.

On the other hand taking exposure to market risks requires specific skills, understanding of a client’s liquidity requirements, infrastructure, and an expert network to source, assess and execute investment opportunities; it’s not a salesman job, he is better equipped for inviting you to Wimbledon and for wining and dining you.

“The greatest risk to man is not that he aims too high and misses, but that he aims too low and hits.”
Michaelangelo

Fabrizio Ladi Bucciolini, 2/09/2012

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