Originally published: July, 2003 (Phillips, Hager & North Investment Funds Quarterly Report)
Context of the article: In 2003, there was a lot of press on the conflicts of interest that are inherent in the investment industry. At that time, the focus was on the analysts and investment bankers on Wall Street. The spotlight hadn't yet turned to the mutual fund industry, but it would very shortly after this column was written. The article does an assessment of how the wealth management industry is doing in managing its conflicts of interest, specifically the conflict between the company's bottom line and the clients' best interests.
A few months ago, The Wall Street Journal published an editorial about conflicts of interest in business. At the time, attention was being focussed on the unscrupulous research practices of many major U.S. brokerage firms, which were then negotiating a legal settlement with federal regulators. As a counterpoint to the headlines, the author opined that conflicts of interest exist everywhere in the world of business. No matter what field you're in, you deal with them every day. The point of the article was that it would be ridiculous to think we can sweep Wall Street clean of all conflicts of interest, regardless of new regulations or industry restructuring.
If that is the case (and I concede that it is), then let us ask: How is the Canadian wealth management industry doing in dealing with conflicts? In considering this question, we should turn our attention to the conflict that rests at the heart of the business: the balance between what�s good for the financial institution and what�s good for the investor. From my station, I don�t think the industry has done very well in this regard.
Consider the following examples, which are specifically related to the distribution of investment products:
- High costs. The mutual fund industry has grown tremendously over the last decade. Logic would suggest that this growth should bring economies of scale, which in turn should lead to operating efficiencies and lower costs. And yet, the cost of owning a mutual fund in Canada - as measured by fund MERs - has not come down. Indeed, a recent Morningstar study pointed out that MERs have risen in recent years. While the methodology and details of the study have been debated actively, the final conclusion does not change. From a cost perspective, the mutual fund buyer has not benefited from the growth of the industry.
Emphasis on accumulating assets rather than client returns. The majority of mutual fund distributors are primarily focused on sales, with seemingly little regard for what is best for the individual investor. Emphasis is put on what will sell, instead of on products or services that fit investors' long-term needs. As a result, we see advertisements for technology funds at the top of the stock market cycle (playing to investors' greed), and for money market and other conservative funds at the bottom (responding to investors' fear). The industry has been too quick to take the path of least resistance for the sake of enhanced short-term sales.
- The "Cycle of Hope". The industry is continually feeding its clients into what I've dubbed the Cycle of Hope - whereby investors are moved from one product or strategy to the next, selling what has not worked in the recent past and buying what will be "the next great thing" (generally based on what has worked in the recent past). The result, as reaffirmed in study after study, is that investors' returns are considerably worse than the returns of the products they purchase, because of when they buy and sell.
- Deceptive packaging. In recent years, there has been a proliferation of "packaged" products (structured income products, index-linked GICs, principal-protected funds, wrap accounts, etc.) that claim to provide simple solutions to complex problems. Unfortunately, the products themselves tend to be quite complex. This makes it difficult for investors to assess the risks they are taking and the fees they are paying for the convenience. On the latter issue, packaging allows the provider to add-in an additional layer of fees (such as offering expenses, capital guarantee fees, administration and custody charges, servicing or trailer fees, and management fees). In my view, these packaged products once again demonstrate the industry's insensitivity to the fees investors are paying.
- Business goals misaligned with investor goals. The core strategy of a few large financial planning companies is to acquire new clients through acquisition and marketing, and then convert their portfolios from third-party mutual funds to funds managed by the companies' in-house teams. Their clients have access to virtually all products available in the market, but the companies' commission schedules and marketing materials are strongly biased in favour of their proprietary product. This subliminal business strategy - which is quietly communicated to employees and shareholders, but is invisible to investors - structurally and formally puts the company's goals ahead of its clients' best interests.
- Risk? What risk? The industry has done a poor job of explaining risk and reward. At the most basic level, investors are promised more returns without being fully briefed on the risks they are taking. They are led to believe that they can attain enhanced returns without taking any additional risk.
Why is this happening? Why is the consumer being so poorly served?
The biggest factor is what consumer advocate Glorianne Stromberg calls the "knowledge gap". She makes the simple but profound observation that in the wealth management industry there are those who know (the financial professionals) and those who don't (individual investors). All the advantages go to people who know. (I'm reminded of the old poker adage: if you look around the table and can't figure out who the patsy is, it's you!) The increased use of packaging has served to widen the knowledge gap even further - only a seasoned analyst can figure out how the products are structured.
The knowledge gap puts the onus on the product providers to find the appropriate ethical and economic balance. They alone have to walk the line between what is good for their company and what is good for their client. If investors are unable to assess value or understand what they are buying, there are effectively no counterbalances in the system. Government regulations do little to protect the consumer in these cases.
The bear market has shaken out some marginal practices from the wealth management industry. But in my opinion, there is further to go to find a better balance between what's good for the financial institution and what's good for the investor.
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