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Who has an ax to grind?

The investment industry is loaded with conflicts of interest and many are not obvious. Disclosure often occurs, but it can be very difficult for the investor to understand the implication of that conflict. The amount of compensation to firms and their salesman is difficult to unravel, but higher fee commissions reduce net investor return. According to a September 30, 1996 Fortune article, "small investors pay 5 to 20 times more to trade a stock than institutional investors do. In most industries, wholesale gets a break over retail, but usually not 20 to 12." Let's look at some of the most alarming conflicts.

Market making and selling securities from the broker's account Frequently, research reports on specific securities contain the footnote, "XYZ firm makes a market in this security." In other words, they own it. When the risk of owning it increases, it is not uncommon for that firm to motivate their salesman to unload it by offering extra commissions. The industry vernacular for this practice of offering added commissions is "feeding raw meat to sharks."

This phenomenon also takes place with bond inventories. Unless an investor is extremely well versed in the bond market, it may be difficult to realize the impact of bond commission on price.

Commissions. This inherent conflict is more obvious. Whenever the product is paying the professional and not the client, motivations change. A study in the 1996 Fall/Winter Financial Consultant found that a large number of brokers earn a disproportionate share of their income near the end of the production month. This probably results from brokerage industry's focus on monthly production and the broker's pressure to meet commission goals. This is obviously in the broker's best interest, not the clients'.

Insurance products, retirement plan services, and many investment products have commissions deeply buried and can be quite difficult to understand. Commission disclosure is rare in the insurance business, and although commissions are disclosed in mutual fund prospectuses, the impact on returns is sometimes overlooked. Front-end load mutual funds are becoming less common, but salesman can receive large compensation from B shares and C shares with commissions buried in the internal costs of the funds that are protected by heavy surrender charges.

Wrap accounts. Wrap accounts were designed to give investors professional management with an all-inclusive fee in lieu of commissions. But in many cases, the commissions are also buried in the products. Yes, mutual funds can be "no load," but some may also pay the brokers on assets in the wrap program. Additionally, many of the firms do significant securities trading with these brokerage firms. How objective can a firm be when it is recommending managers or funds, and these same firms are lining the pockets of the broker? It is crucial for the investor to understand the process that was used to get to the final recommendation.

Sales contests, prizes, and dinners. Sales contests are becoming less frequent, but even-fee only firms can be swayed by relationships. Objectivity is crucial in ensuring that the client receives untainted recommendations. Relationships between consultants and money managers can become quite cozy and judgment can be swayed. The investor needs to truly understand the process used in filtering the investment products or managers.

In-house products. If a particular investment style is readily available in the marketplace, why a proprietary product or fund is being recommended should be questioned. According to an article in the November 20, 1997, Wall Street Journal, "The nation's top brokerage firms have a problem on their hands: They're having trouble selling their own mutual funds. The funds' performance is nothing to brag about either." Retirement plan sponsors need to also be skeptical of insurance company products with a guaranteed income contract or stable value product attached. These are often huge profit centers and the cost may only be deciphered by a comparison to the marketplace. Additionally, money market fund costs vary greatly. There is a direct correlation between yield and cost with these products. The lower the internal expense, the higher the yield. Is it any wonder why brokers offer "free" custody?

Soft dollars. This well-oiled system allows money managers and mutual funds to pay for research, software, and other business that benefits the client. The more the trading, the more a firm has in commission "credits." Products purchased with soft dollars aren't necessarily bad since most do benefit the client. This is clearly a conflict of interest, and disclosure is required. The SEC has been fairly aggressive in examining investment manager soft dollar practices.

Managers/funds evaluating their own performance. Investors must be skeptical of how managers present their firms' performance. There are plenty of credible managers, but it must be expected that managers will put themselves in the best light possible. There are numerous examples of firms using questionable statistics and misleading benchmarks. In addition, with separate account managers, dispersion of returns between accounts can make the track record managers' report for marketing purposes somewhat misleading. Smaller accounts are often managed differently and results can vary greatly from the composite.

Having an objective consultant assist with manager evaluation and performance monitoring can help. Relying on managers' for evaluation is like having the fox guarding the henhouse.

Limited product array. Most brokerage turns offer a small percentage of the entire universe of investment products. Typically, true no-load investments won't be on their platform. By the same token, fee based advisors can also be limited by custodial alternatives. Many financial planners seem to favor annuity products, but with recent tax law changes, the viability of annuities can be argued. Furthermore, large commissions are buried in the products and some planners have significant limitations in offering product. Additionally, annuities are sister products to insurance and may be more familiar to planners who focus on insurance.

Planning points to a favored solution. How often does the financial or estate planning result in an insurance recommendation? It may be necessary, but the planning can certainly be tainted if an insurance commission is a part of the compensation. Ideally, a consultant's compensation structure should be determined up front, regardless of the solution. Therefore, the advice should be objective and in line with the investor's best interest.

Full Disclosure

Dan Tully, chairman of Merrill Lynch, in a report to SEC Chairman Arthur Levitt said, "The prevailing commission based compensation system inevitably leads to conflicts of interest among parties involved." Full disclosure of conflicts of interest is important when dealing with investment professionals. However understanding the impact of these conflicts is equally important; understanding who is truly working on the investors' behalf and who has an ax to grind. Furthermore, "fee-based" doesn't necessarily mean commissions aren't involved.

Richard Todd is a certified investment management consultant and a principal at Innovest Portfolio Solutions in Englewood, Colorado. (303) 694-1900.
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Title Annotation:conflicts of interest in the investment industry
Author:Todd, Richard
Publication:The CPA Journal
Date:May 1, 1998
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