Brent Sheather: Investing in a conflict of interest?

Conflicts of interest come in all shapes and sizes. Photo / Thinkstock

One of the obstacles facing a retail investor seeking good financial advice in NZ is the conflicts of interest some, if not all, market participants are subject to. Investopedia defines conflicts of interest (COI) as a "situation where a professional has a vested interest which may make them an unreliable source of advice. The interest could be money, status, knowledge or reputation for example. When such a situation arises the party is usually asked to remove themselves and it is often legally required of them."

Investopedia may need to update their definition because in NZ, according to one expert writing on a financial adviser website, "conflicts of interest are not wrong in themselves as long as they are properly identified and managed effectively and transparently". What the expert seems to be suggesting is that if you tell everybody you're conflicted via a detailed disclosure statement and give advice which is conflicted, ie don't put your client's interest first, that is perfectly okay.

Well I am not so sure and nor is the Auditor General. In a 2007 paper on COI the Auditor General stated that identifying and disclosing the conflict of interest was necessary but where the Auditor General differs from our expert is that he added that "the conflicted person needs to then decide what action is necessary to best avoid or mitigate any effects of the conflicts of interest".

COI's seem to crop up all the time. Just this week, on another specialist financial planner website, an intermediary argued not only that passive funds weren't a good deal for investors he had also manufactured some statistics to show that higher management fees gave higher returns. The spurious data reminded me of the local fund manager's share portfolio that would have done well had it not owned a couple of stocks that went down. It transpired that the business of the adviser concerned involved promoting local or international active fund managers to NZ financial intermediaries. One imagines that not many passive funds enlist his services. Sounds like we might be conflicted!

Conflicts of interest come in all shapes and sizes. A while ago in some coverage of the proposed class action against the banks a partner in a law firm was asked to comment on the prospect for success of the class action . Predictably he gave its viability the thumbs down but it transpires that most of the major banks were or had been clients of his law firm. LOL.

Virtually all financial advisors are conflicted to some degree or another. It is just the degree to which you are conflicted that differs. When a new client comes to see me with funds to invest I could recommend that they put the money in the bank but I would get no fees from this strategy so bank deposits are not at the top of my list. The key to properly managing that sort of conflict is to ensure that that course of action is included in the client's recommendation to the extent that it is represented by best practice. In the "should I have the money in the bank" issue best practice tells us that someone with a short term investment horizon should have all their money in the bank. A typical pension portfolio has a proportion of its fixed interest assets in short duration bonds so that is the extent to which money in the bank would be an option for a client with a long term investment horizon.

Of course the performance of many professions are impacted by COI but where perhaps the financial advisory industry differs is the extent of the impact of the conflict. For example, an advisor can get paid a 2-3 per cent commission and a trailing fee for years if he or she recommends a high cost fund. Alternatively if he or she chose a low cost actively managed fund, or a low cost passive fund, his/her remuneration could be reduced by 60 per cent or more. Maybe it is the extent of the impact of the conflict that differentiates our industry.

Politicians and the regulatory authorities began to look closely at COI's in the financial sector subsequent to collapse of the finance company debenture industry. The popularity of finance company debentures amongst financial advisers was a manifestation of the biggest conflict of interest there is, commission payments. Because finance company debentures paid high rates of commission some members of the investment advisory industry recommended these products to clients.

Anecdotal evidence suggests that many retail investors' fixed interest portfolios were largely made up of finance company debentures and if one contrasts these portfolios with best practice as evidenced by the high quality government stock oriented portfolios of institutional investors it is quite clear that a good part of the industry was totally conflicted.

There are two ways of dealing with conflicts of interest; the cheapest, and the one which much of the industry has adopted thus far, is to spend hundreds of thousands of dollars on lawyers and consultants preparing a detailed disclosure document outlining your conflicts. That is what the expert writing on the financial planning website recommended.

Coincidentally that is a service his firm provides. Oh'oh I think we are conflicted! The other less obvious alternative and certainly less profitable way of dealing with a conflict of interest is to simply get rid of it. In Australia and the UK the regulatory authorities have acknowledged the fact that most consumers don't have any more of a clue about their prospects for being treated fairly after reading a disclosure document, and that is assuming that they actually do, so what they have done is removed the major impediment to the receipt of good advice for retail investors ie they have banned commission. This will probably mean lower fees for the public but financial planners would also benefit because those disclosure statements would cost a lot less to prepare.

The industry spin on conflicts of interest is particularly clever. The spin suggests the bigger and more detailed the disclosure statement the more comfortable the client can feel. Well duh, call me a sceptic but it seems that the larger the disclosure statement the more conflicted the advice is likely to be and the less likely the adviser will have the advised's interest in mind. But maybe I am conflicted.