Brent Sheather: Adviser regulation fine, if they listen

The clean-up of the investment advisory sector is picking up momentum. The Securities Commission has just released a paper detailing its initial thoughts as to how it might better regulate and supervise financial advisers.

The paper outlines the regulation and supervision of financial advisers generally, with particular reference to the Financial Advisers Act 2008 (FAA). The act's purpose is "to promote the sound and efficient delivery of financial advice and to encourage public confidence in the professionalism and integrity of financial advisers".

The FAA splits advisers into two groups - those people who advise on managed funds, shares, bonds, etc and those people who deal in less complicated products like bank deposits and insurance policies.

Advisers wishing to deal in the first category will have to be authorised by the commission and registered with the Companies Office.

If you work for a large advisory firm which is itself registered with the Companies Office, you don't have to be registered as an individual.

If you work for a large registered advisory firm and part of your role is to sell or advise on products of which your employer is not the issuer, then you will need to be an authorised financial adviser (AFA).

To become authorised the commission needs to be satisfied that the adviser exhibits the following characteristics:

* Is registered.
* Is of good character.
* Meets the level of competency, knowledge and skills specified in the code of an authorised financial adviser.
* Has not been convicted of an offence punishable by imprisonment of six months or more.

The key question is what level of competency, knowledge and skill will be required? Any decision on competency will be determined by a soon-to-be appointed code committee. The commission has issued a staff discussion document on competence.

Anyone familiar with investment adviser regulation and behaviour in the US and the UK might also wonder if it will make any difference anyway. It seems that many of the authors of the horror stories involving investment in finance company debentures, CDOs and so on are "qualified" financial planners.

Just last week Tamsyn Parker wrote in the Herald about how a qualified financial planner managed to lose almost all of a poor woman's money.

So the question is, are the financial planning courses teaching the wrong stuff or are the advisers just ignoring the lessons? The high incidence of bad advice suggest that something sure ain't right.

The bottom line for retail investors is, would the new regulations have dissuaded advisers from mis-selling the likes of finance company debentures, Feltex shares and CDOs?

Will it mean that financial advisers begin selling exchange-traded funds with the lowest expense ratios rather than homegrown and Australian products with fee levels up to 20 times greater? Will stockbrokers continue to recommend individual stocks when overseas research says you need to own a minimum of 50 stocks to be properly diversified?

Will our venerable but inappropriately named trust companies wake up and start recommending the best and the lowest-cost managed funds on offer instead of pushing their poor clients into their own high-cost products?

We will have the answers to these questions soon enough but it is easy to be sceptical: old habits are hard to break, greed is one of the seven deadly sins and the fundamental weaknesses of the financial advisory business model remain.

Firstly, many financial planners are remunerated by commission and are thus incentivised to sell whatever has the highest fees at the time, rather than having regard to what the client should own. Remember also the reality that higher-risk products pay the highest commission.

Secondly, with unrealistically high annual fee structures (most advisers' underlying fees, management and monitoring amount to 2 per cent or 3 per cent a year of the worth of a portfolio), advisers need to favour risky products. For example, short-dated government bonds only yield about 3 per cent to 4 per cent so these generally don't get on the radar screen as half the return on these bonds will go on fees.

The financial planning industry knows that Mum and Dad will figure this out sooner or later, thus the adviser is inclined to recommend a higher-risk bond or finance company debenture which can sustain the high fee and still deliver a reasonable return after fees. The problem with this strategy is that higher-risk bonds, in times of market stress, change their spots and act like equities so Mum and Dad lose the stabilising feature of low-risk bonds in a portfolio because they then don't own any genuinely low-risk assets.

Thus when everything turns to crap like it did in October last year, investors with all their money in risky assets tend to be the ones that sell out at the worst possible time, whereas those with genuinely low-risk bonds, which have gone up in price in response to the negative environment, are better equipped to hang in there.

Angus Dale-Jones, the commission's director of supervision, commented that these sorts of problems would be addressed primarily by the code of professional conduct that will be formulated by the code committee and, secondly, by the commission, which will set the terms and conditions for the authorisation of advisers.

There are other grounds for optimism and, perversely, they are coming from Australia, where the financial services industry is apparently moving to phase out commission on investment products.

Financial advisers can either be paid by way of commission from the product provider or by way of a fee directly from the client. Bond-based products typically pay lower rates of commission than equity-based products and the safest investments, like government bonds, pay no commission whatsoever.

Similarly, exchange-traded index funds which have the lowest management fees in the industry don't pay any commission or trailing fee.

No surprises, then, that commission-based advisers don't generally recommend government bonds or ETFs. In contrast, the fee-based model, in which an adviser charges the client a set percentage of the funds to be invested, is potentially more attractive to investors, providing the percentage charged is the same for all products sold.

Under the fee-based model a financial planner will be disinterested as to whether he or she sells bonds, property or shares and is thus able to focus on what is good for the client, rather than what maximises income.

The removal of commission and trailing fee payments by product providers would change the investment advisory landscape in an instant and do more "to promote the sound and efficient delivery of financial advice and to encourage public confidence in the professionalism and integrity of financial advisers" than any legislation ever could.

Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.