In the interest of time and space, I will give the conclusion to this article up front. In that way, if you are pressed for time, or get too bored reading it, you don’t have to skip to the end, to get the point.
Financial advisors who still recommend or still have clients invested in any of the 495 mutual funds and investment firms who were charged with breaching their responsibility to shareholders and investors in the last 12 months should fire the firms now. By continuing a financial relationship with a firm which knowingly has committed ethical fraud upon its clients puts you in the same company.
Lost amid the rubble of the fiduciary meltdown which occurred in the investment management community has been the impact on clients.
Special deals, spotty disclosure (or the lack of even that), blatant disregard for rules and regulations and the complete dismissal of the trust imposed on them by their clients has resulted in these firms perpetrating civil fraud upon their clients, which so far has resulted in more than 20 principals arrested, 10 barred from the industry and estimated damages of more than $10 billion.
In an attempt to recover, firms have had to cut their fees, make special disclosures, fire principals, throw out portfolio managers and even dismiss the founders. With these abuses perpetrated, condoned or even encouraged at the highest levels of these firms, it is ludicrous to assume that there has been no impact on the investment merit of the firms in question. In some cases, the investor fraud was not illegal, but merely unethical. So, in the best situations, should you be allowing your clients to invest with parties who are unethical? Since investment management consultants and most other financial advisors have at least some fiduciary responsibility toward their clients, the only ethical answer is a resounding “NO”. Furthermore, clients whose advisors have not recommended replacing the firms in question should fire their advisors.
Conventionall wisdom in the financial advisory world has said that if clients are happy or at least satisfied, then don’t rock the boat. After all, advising your client to change investments or investment advisors can be disrupting to the client. Financial advisors have historically been reticent to disrupt a client relationship for fear that it will give the client a chance to change advisors.
There are more than 5500 mutual funds in the country. 495 of them have been charged with breaching their fiduciary responsibility to shareholders. Led by NY Attorney General Eliott Spitzer and Paul Roye and Stephen Cutler of the Securities and Exchange Commission, regulators and government agencies have imposed fines, ordered fee reductions and jailed and permanently banned perpetrators from the industry.
The media misled investors to believe that mutual funds have been the culprits, and have tended to downplay the real culprits—the investment advisors, portfolio managers, traders and principals who ignored the fundamental principles of fiduciary responsibility.
Our attention has been directed to late trading—the practice of allowing certain favored investors to take advantage of after hours activities and trade on information not available to the rest of us.
But late trading is more than that. It means that persons in a decision making position has allowed preferential trading privileges to certain “favored” investors. Introduce the concept of quid pro quo. Why certain investors? Let’s think about some possible reasons. Could it be because said certain investors placed large assets with the fund? Or perhaps, the investor is a significant institution, say a center of influence or referrals. The point is that allowing late trading is not a random act of kindness by the fund. It’s illegal, it’s fraud upon shareholders and it is a breach of fiduciary responsibility by the fund principals as well as a lapse in oversight by the fund boards of directors.
Market timing has gotten attention because again, “certain” firms have been permitted to trade in and out of funds quickly while we poor long term investor slobs are waiting for tomorrow’s USA Today to see how we’ve done. We pay the added expenses, lowering our already paltry returns. The problem with market timing is that while it is not specifically illegal, the firms which permitted the activity did not disclose the activity in their prospectus. Some have actually said that they will not permit the activity, yet allowed it anyway. Asking the same question, why only certain firms, leads us to the same answer–quid pro quo.
Other abuses which have been committed by funds include front running portfolio managers who so fervently believe in their own research that they must trade ahead of the rest of us to list it out, the blatant disregard of regulatory sales practices and the failure to disclose revenue sharing deals to investors.
It is not a cadre of back office clerks or rogue traders who have committed these crimes against shareholders. It is fund presidents, senior executives, advisory firms officers and chief portfolio managers who have been the guilty perpetrators.
So, the financial advisory community has generally adopted the analytical approach in addition to the sales approach. The analytical approach says if the fund is meeting its investment objectives, if the performance has been consistent, and the client has been satisfied with the results, don’t rock the boat. From a higher level analytical approach, if the science of investment management consulting tells us that the fund is okay for investors, then it’s okay.
What is being ignored is a fundamental ethical question—Do you want to recommend or even allow your clients to be invested in firms which have blatantly thumbed their collective noses at their fiduciary responsibility to their shareholders? This is part of the “art” of investment consulting not found in analyst’s textbooks. Trying to compromise the art by balancing it with the science is like trying to reconcile Darwin with Creationism. Don’t try, trust the art.
Fiduciary responsibility is not rocket science. You don’t need a certificate from some overpriced course to learn its principles. A fiduciary is someone who is responsible for somebody else’s money. Fiduciary responsibility is the ethical treatment of somebody else’s money. Courts and regulators regularly apply a sophisticated theory called the “Duck Theory” when assessing fiduciary responsibility. If it looks like a duck, walks like a duck, smells like a duck and acts like a duck, it’s a duck. Fiduciary status will be defined by the actions of the party in question. If the client believes a party is acting in a fiduciary capacity, it will be one.
Fiduciary liability is personal and impersonal. Personal in that fines and penalties assessed have to be paid directly by the perpetrators. Impersonal in that courts don’t care who is responsible—they’ll get anybody (even Martha Stewart).
Mutual funds are trusts or act like them. Using fund assets for personal interests rather than those of the shareholders is a breach of that trust, and it’s either illegal or unethical. Favoring one group of investors over another to the potential detriment of the other or for the benefit of the fund manager rather than all the shareholders is wrong and has no place in the investment management world.
Investment Consultants are trusted by their clients to provide unconflicted, unbiased recommendations and advice. They too have a fiduciary debt to the client and accordingly are considered “special skills persons” by the courts. Investment Management Consultants have an obligation to adhere to only the highest ethical standards like those propounded by organizations such as the Investment Management Consultants Association (IMCA) and the CFA Institute (formerly AIMR). There is no place in investment consulting for recommending to or allowing a client to continue to invest in a firm which has perpetrated ethical fraud upon its client.
The Investment Consultant’s charge is to provide full disclosure and adequate education to their clients, while ensuring that the information the client bases decisions upon is complete and accurate.
Investment options must be evaluated solely according to the client’s investment objectives, documenting the recommendations, fully explaining market risks, providing full disclosure, including all fees and cost comparisons, explaining that past performance is an unreliable predictor of future performance, keepiing the investment process an ongoing one and being a fiduciary. If a consultant can’t accept all that, perhaps they should consider a career in politics where the standards are lower.
At the end of all this well be the age of investment transparency with a more open, more shareholder-oriented investing world. Those who play by the rules will be winners and will benefit by remembering they’re dealing with Somebody Else’s Money.
John Lohr is the author of The Fiduciary Sale, The Director’s Cut (with Ian Lohr), Investing as a Fiduciary, the Director’s Cut (with Ian Lohr) and 11 other books for Financial Advisors and investors. Available at www.islepress.com.