What Investors Should Know About Conflicts Of Interest

The continuing debate over regulatory implementation of a fiduciary standard on all financial services providers often misses an important point about conflicts of interest.

But not everyone has missed that point! A recent article in The Wall Street Journal (“New Financial Advisor” by Peter Finch, January 29, 2015) provides individual investors with some helpful ideas about fees and conflicts. I would like to expand on one of the very important points raised by the author,

“There isn’t one right way to pay an adviser. But as [one investor] learned, it is vital to know how yours makes his money—and to understand any potential conflicts of interest.” [Emphasis added.]

Note that Mr. Finch counsels understanding potential conflicts—not eliminating them.

Very often, the debate about the fiduciary standard has been based on a desire to eliminate potential conflicts of interest. However, conflicts of interest are not inherently bad.  In fact, a key component of a market is the participation of parties with opposing interests: potential sellers (who want the highest price possible) and buyers (who want to pay the minimum amount necessary).  The stock market (or real estate or any other market) could not operate without the opposing interests between sellers and buyers.  But the stock market is a (mostly) transparent market.  It is not realistic to seek to eliminate conflicts of interest.  The conflict of interest is necessary for a market to function. Without a market to set prices and provide liquidity (the ability to convert holdings into cash), investors would have a vastly reduced selection of products with which to customize their portfolio to suit their objectives.

What everyone should demand, though, is transparency and honesty about those conflicts.   As Mr. Finch points out in his excellent article, buyers should recognize the conflict, and—I would add—demand transparency and do business only with those who deal fairly and honestly.

When the buyer and seller are both fully informed and aware of the conflict of interest, both parties are free to decide whether or not to enter into a transaction. However, when the seller consciously and deliberately obscures or denies the conflict of interest, it should be a red flag to the potential buyer.

Focusing on the conflict of interest between financial services professionals and their clients is important—but trying to eliminate conflicts of interest risks unintended consequences. The real concern is self-dealing—when an advisor*, from a position of trust, takes advantage of their relationship with the client to enrich themselves at the expense of the client.

Real World Application

What does it mean to work with a professional? It means working with a person with advanced or specialized knowledge, acquired by a prolonged course of instruction or study. By definition, then, by relying on a professional, one is seeking the benefit of their specialized knowledge. Because the professional has more knowledge, they have an advantage over the client. And, the greater the advantage, the more important it becomes that the professional is trustworthy and ethical.

In some cases—as with a fiduciary—there may be a legally enforceable expectation that the client’s needs will be placed first. In other cases (as with a brokerage relationship), while it may not be a legal prerequisite, there are many examples of brokers who adhere to the higher standard of care.  Investors should not assume that financial services providers that are not fiduciaries are not motivated by the best interests of their clients. Neither should working with a fiduciary mean that an investor should blindly hand over supervision of their assets.

Trust but Verify

Investors may not fully understand all of the details of the products or services they are considering**, but they should fully understand how the various parties are being compensated. (As a matter of fairness, buyers should expect to pay for expertise or services rendered.  Demanding a zero cost transaction or free advice actually encourages sellers to hide their fees.) The more complicated the product or proposed solution, the more difficult it can be for the client to fully understand the complexities of the product—and therefore, there is a greater level of reliance on the professional judgment of the person making the recommendation.

While there may be a pre-existing level of trust between the parties, it is important to trust but verify. Follow the money to recognize potential conflicts of interest, and ask plenty of questions so that you can understand and be comfortable with the rationale for the recommendation. Working with a provider with a fiduciary obligation will mitigate the conflicts of financial interest, but it remains in the client’s best interests to probe and understand the basis of any recommendation. Due to the business models of the various providers in the financial services industry, investors may find a broader selection of products from non-fiduciary providers.

Conclusion

Conflicts of interest are not inherently bad. It is not realistic to seek to eliminate conflicts of interest.  What everyone should demand, though, is transparency and honesty about those conflicts. To protect against self-dealing, investors should keep asking questions until they fully understand compensation and fees, recognize conflicts of interest and the rationale for any recommendations. Favor providers who are transparent about potential conflicts of interest and all of the fees and charges involved.

Investors may find it appropriate to work with a broker (for product selection) and a fiduciary (for planning and guidance). Keep in mind that there will be additional costs incurred from working with additional professionals, so that it may not make economic sense unless the investor has sufficient assets to justify the incremental costs involved. Finally, in circumstances involving meaningful amounts of capital or risk, it may be prudent to seek a second professional opinion.

 

*Most publications prefer the use of adviser. My preference is to use advisor when referring to a professional advice giver. Both spellings are considered correct.

**Imprudently, many investors in today’s low interest rate environment shop first based on yield or return, without fully understanding the nature of the potential investment. Warren Buffett has stated many times that he does invest in what he does not understand. My approach has been to apply the taxi meter approach: the longer I sit in the cab, the more it’s going to cost me; the longer I have to spend trying to understand a security or product, the more yield I would expect to see offered. For every moment I spend on the phone listening to an explanation, I imagine an old style taxi meter, denominated in basis points—when the flag drops, it starts at the risk free U.S. Treasury yield, and keeps rolling higher until I hang up the phone.

 

Income Investor Perspectives

Exploring ideas of interest to the income investor

 

February 17, 2015

 

The opinions expressed and the information contained herein is based on sources believed to be reliable, but its accuracy or appropriateness is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

 

©2015 Patrick F. Luby

All Rights Reserved.

 

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