Double-dipping, gouging and low returns

By GARETH MORGAN - Part 2

If a door-to-door brush salesman told you that one brush in his quiver was better than another, would you be convinced he was acting in your interest? Would that advice be worth anything? He gets paid no matter which brush you buy - just buy a brush, won't you?

Yet this is precisely the practice that permeates the so-called financial advisory business in New Zealand. At least with a brush salesman, the disguise is wafer thin - only the really gullible believe he has any purpose apart from selling you a brush.

But when somebody charges you as your investment adviser, validated by credentials from a national professional body of advisers, you might be forgiven for thinking that he is what he claims he is.

The standards required of financial advisers are so low that a person can tell you he is there to advise you (and in so doing leave you to infer that, like your accountant or your lawyer, your welfare is his professional concern) when there is nothing further from the truth. His sole purpose is to sell the products of fund managers, from whom he receives at least part of his remuneration.

White-shoe commission abounds in the financial advisory business. Insurance companies and fund managers have so compromised the investment advice business that most advisers double-dip, receiving commissions from the product providers as well as charging fees to their clients, all the while misleading investors that they are their advisers. The conflict of interest is total.

Investors' interests rank last in a very long chain, perpetuating an arrangement wherein mum and dad investors systematically are fleeced of most of their returns.

There is nothing wrong with self-interest, of course, but when its pursuit comes at the cost of gouging investors' returns, and the market is insufficiently competitive to eradicate the practice, there is at least a prima facie case of market failure.

Our detailed examination of the charging regimes for investment products and providers has illustrated just how far down the chain the investor is. One way to demonstrate how divorced investors become from their rightful returns is to ask the question, how much does one have to earn from these things, just to avoid losing one's wealth?

In this experiment we are simply trying to find out the gross return a product must give to deliver a zero return - paltry, for sure, but it beats losing money.

Starting with the ideal option of no fees and no tax on capital gains, if inflation is 2 per cent, then to avoid going backwards, you have to earn 2 per cent after taxes. Investing in shares involves paying taxes on dividends, so the actual return required is 2.2 per cent, under our assumption for all shares that 30 per cent of the return comes by way of taxable dividend and 70 per cent from capital growth.

But once we move beyond this ideal, the required return gets significantly higher, as the table (for an investment of $100,000) summarises. The reality is that an investment via an intermediary has to provide around 6 per cent just for the investor to avoid losing wealth.

What is the chance of a fund making a 6 per cent nominal return? US data suggests the stockmarket will manage that 65 per cent of the time; the average fund 20 per cent of the time, or one year in five.

There is no doubt those products are so bad that only misinformed investors would persist in throwing good money after bad. It is, indeed, a triumph of marketing over transparency that they continue to do so.

The institutional fund managers are the primary party misleading investors, assisted by field lackeys, which is what any commission-rewarded product salesman is.

Increasing funds under management rather than maximising the performance of those funds is the key to bottom line success for fund managers. That is one reason financial services companies continually lobby politicians to address the dearth of savings.

The Cullen Fund and reconstituted Government Superannuation schemes are testimony to their success. Investment performance is very much a second-order priority for these firms. Indeed, the cartel of fund managers, financial services companies and advisers provides each party with a security of income from the saving public. Financial services companies and brokers provide the platforms for undercapitalised one-man-band advisers to be in the field, working their powers of persuasion to capture household savings.

There are few, if any, advisers in New Zealand who are adequately qualified in investment markets; who are equipped in more than an amateur fashion to understand the nexus of social, economic and financial forces that shape investor returns. By far the majority are very familiar with the characteristics of their sponsors' products, what commissions they deliver and how to sell.

There is nothing wrong with salesmen, whether they be salaried or commissioned. BUT there is something wrong when that person perpetuates a myth that their self-interest is served best by the investor getting good returns. On the contrary, the interest of the salesman is best served by the readiness with which you buy his product, and by the volume he sells.

The regulatory environment that has permitted this misrepresentation by advisers and their product provider/employers has much to answer for in the abysmal performance of New Zealanders' savings. Small wonder despairing investors turn their back on managed funds and develop a preference for residential property. Too often investing in managed funds has done no more than line the pockets of the finance houses.

For markets to function efficiently participants must have full information. The conspiracy between investment advisers and product and platform providers ensures investors do not get all the information they need.

Even where there is disclosure it is often in a form designed more to baffle than to assist. In our survey we found it very difficult to get data from advisers on past performance; indeed, a few simply said it was not available.

In the US the behaviour of the financial services industry has been so corrupt that jail sentences and fines have become almost passé. A number of protective regulatory measures are being implemented.

* Fund governance is being separated from the affairs of its manager.

Virtually always the promoter of a fund to the public becomes the manager or administrator of the fund. Through this route they ensure the fund serves their objectives primarily, rather than those of investors.

Fees and expenses, many of them undisclosed, end up lining the pockets of the manager. In the US the chairmanship of any fund promoted to the public must now be independent of the manager.

* Advisers are being separated from fund managers.

In New Zealand we have made some small progress with the 1997 Advertising Board ruling that it is unlawful for an adviser to use the word independent while selling a product that he has an interest in as promoter, manager or administrator. Yet it is still possible for advisers to call themselves independent while receiving sales bonuses for selling more of a provider's product.

* Disclosure is increasingly seen as a weak remedy of the information imbalance.

In order to take advantage of full disclosure, the investor has to be able to understand the information provided. Obfuscation is a skill perfected by insurance companies and in the UK, Australia and the US disclosure is generally regarded as necessary but insufficient to address the information disadvantage.

* Trustees are being required to step up to their supposed duties.

There is a readily available cop-out for trustees from their duty of care. They can say in their defence that they were taking professional advice. The screws are being tightened on this wimpish escape, with the intention that trustees shoulder their responsibility or resign.

In summary, retail investors receive paltry returns because they are in the dark about how much they are being gouged, there is minimal onus on providers to reveal all fees and expenses in plain English, and the advisory business is corrupted by the commissions providers pay, some declared, many hidden.

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